Solving the Social Security Tax Bubble Mystery, Ep# 101

Are you in the Social Security tax bubble?

Tax rules are complicated enough, and Social Security benefits during retirement years add another layer of complexity.

Your Social Security income can cause your actual tax rate to be much higher than expected. Not understanding how and when Social Security benefits are taxed can lead to an unpleasant surprise when Uncle Sam comes calling.

We’ve outlined what to look out for below.

How does Social Security affect my overall tax rate?

Half of your Social Security benefits count toward your combined income. This includes your adjusted gross income plus nontaxable interest. If your combined income reaches a certain threshold — $25,000 for an individual and $32,000 for a married couple filing jointly — you’ll have to pay income tax on anywhere from 50% to 85% of your Social Security benefits. The Social Security website has more information on the percentage of benefits taxable.

Why are tax brackets crucial?

Paying close attention to your income tax brackets can help you avoid the Social Security tax bubble. This occurs when a retiree’s additional income, such as required minimum distributions from retirement accounts, pushes their overall income past the threshold at which Social Security benefits become taxable. This can result in the additional income being taxed at a marginal rate as high as 41%, even though the retiree may ordinarily belong in the 12% or 22% tax bracket.

Social Security Tax Bubble Individual

This situation is called a “bubble” because the triggering of Social Security benefits taxation, and the outsized rise in taxable income that comes with it, is only in play up until the maximum amount of Social Security benefits are taxed, at which point the tax rate returns to normal.

To prevent taking this tax hit, you can delay Social Security or withdraw from retirement accounts before you’re required to, so you can mitigate the impact of withdrawals in future years.

What else should people be aware of when it comes to retirement and tax brackets?

People spend their working years trying to defer income as a way to limit taxes. Once you retire, this strategy requires a mindset shift. Because it could be best to now add income to maximize the 12% federal tax bracket through Roth IRA conversions or capital gains.

Adding income in this way could reduce your tax obligation in the future, since withdrawals from Roth IRAs are tax-free. This will depend on your income sources and is situation specific.

Once you reach age 70½ (or age 72 if turning 70.5 in 2020 or later per the SECURE act), the required minimum distributions from your retirement accounts could push you into the 22%, 24% or even 32% tax brackets, unless you take steps to lower your taxable income.

That’s why it’s important to do tax planning each year to determine what is optimal in your situation. You don’t want to be hit with a large tax bill when you can least afford it.

What If You’re Already Receiving Social Security Benefits?

There is a path to stop and pause your Social Security benefits. But you have to be at least full retirement age and within 12 months of claiming your benefit. If you are in that group, you can apply for a withdrawal of benefits. There is a requirement to pay back the amount you’ve received thus far.

Taking advantage of this, could prevent you from experiencing higher tax years from age 66 to 70. A handy way to avoid the Social Security tax bubble for a few years and lower your lifetime tax rate.

Anything else to keep in mind?

Social Security taxation, Roth IRA conversions and related strategies are complex and confusing, and poor tax planning could result in thousands of dollars in additional taxes. Additionally, if you are retiring early, the Affordable Care Act could throw you another curve ball. It is important to understand the income levels needed to qualify for the subsidies available. Retirement planning decisions are complicated. Working with a professional will help you make the smartest financial decisions for your specific situation.

Outline of This Episode

  • [1:27] When should you take Social Security?
  • [4:12] A brief overview of the Social Security tax bubble
  • [9:00] Why you should not only consider this year’s tax bracket
  • [13:22] Can you change your mind when to take Social Security?
  • [15:44] Why would someone take Social Security early?
  • [17:32] What are other considerations?

Resources & People Mentioned

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