What is the Tax Torpedo?August 11, 2020
Retirees…are you aware of the “tax torpedo” that could hit you during retirement? Learn more about this potential tax burden.
Are you retired or nearing retirement? If you’re receiving social security benefits, you may be hit with an unexpected tax burden when you file your personal tax return. Here’s what you need to know about the “tax torpedo” that may hit you during retirement.
Federal income taxes are straightforward for most people during their working years since income primarily derives from a paycheck. During retirement, however, taxes can become much more complicated because your income is likely coming from multiple sources with different tax characteristics, including social security.
Social security is part of the retirement plan of almost every American worker. Workers pay into the program typically through payroll withholding. You must be at least 62 or have paid into the system for 10 years or more to qualify for social security benefits. A worker's Social Security benefits are computed based on their average indexed monthly earnings during their 35 highest-earning years.
How is social security taxed?
A calculation based on your overall income dictates how much of your social security benefit is taxable. This calculated income is sometimes called provisional income (PI) and is, in a nutshell, half of your social security benefit plus your other gross income and any tax-exempt interest.
Picture this: Let’s say your adjusted gross income (AGI) is $80,000 and you collect $12,000 in tax-free municipal bond interest and $16,000 in social security benefits, your PI is $100,000 ($80,000 +$12,000+$8,000).
There are two tiers for taxing social security:
Tier 1: If your PI is between $32,000 and $44,000 ($25,000 and $34,000 for single filers), you must pay tax on the lesser of one-half of your social security benefits or 50% of the amount by which your PI exceeds $32,000 ($25,000 for single filers).
Tier 2: If your PI is above $44,000 (or $34,000 for single filers), you must include in taxable income 85% of the amount by which PI exceeds $44,000 (or $34,000 for single filers) PLUS the lesser of the amount determined under the first tier or $6,000 ($4,500 for single filers).
The tax torpedo is the name given to the unexpected way that social security can be taxed, depending on how much other income you may have. It’s triggered if you pay a high marginal tax rate because additional income causes more social security to become taxable. The marginal rate decreases at higher income levels.
Once you start taking RMDs from qualified plans and IRAs (check out our blog for updated information on RMDs) you become a prime target for the tax torpedo.
Bill is a single filer who is normally in the 22% tax bracket and is required to withdraw a $1,000 RMD for the 2019 tax year. The tax on the RMD would be $220, but the $1,000 addition to PI can cause up to $850 of his social security benefits to be subject to tax.
As a result, the effective incremental federal income tax on Bill’s $1,000 RMD is $407 (22% of $1,850). The tax torpedo nearly doubled Bill’s marginal tax rate from 22% to 40.7%!
How can you avoid the tax torpedo?
Effectively dodging the tax torpedo requires advanced planning long before you reach RMD withdrawal age (70 ½ for those born before July 1, 1949 and 72 for those born on or after July 1, 1949). If you wait until then, there’s very little you can do to lessen the burden.
One way to avoid it is to begin making withdrawals from your tax-deferred accounts (IRAs and 401ks) during the early years of retirement.
Before you start taking RMDs, you might consider converting a traditional IRA to a Roth IRA where future payouts are tax free, five years after the conversion.
Questions on the tax torpedo and how you can dodge it? Contact us.