Tax Planning for Social Security Benefits

Article excerpt

Changes in the taxation of Social Security benefits in the new tax law implemented in 1994 may require some changes in decision making processes for taxpayers in the mid-income range that are not readily apparent.

In general, taxpayers in the midincome levels can experience marginal tax rates ranging up to 52% when the effects of Social Security inclusion are reflected in the income mix. This high rate is seen for married taxpayers with incomes in the $44,000 to $70,000 rangean area not uncommon for today's retirees. Married taxpayers with income levels in the $32,()00 to $44,000 range can experience marginal tax rates up to 42%. These marginal rates are significantly higher than those to which these taxpayers are most accustomed.

Background

The Omnibus Budget Reconciliation Act of 1993 expanded the taxation of Social Security benefits by increasing the maximum benefit to be included in income from 50% to 85%. This provision was enacted to stop insulating Social Security benefits from taxation for those taxpayers with relatively higher incomes. Now that the maximum has been expanded to 85%, the potential tax effects of inclusion of Social Security benefits in income can be significant.

The Details: To Whom Does This Apply?

The amount of taxable Social Security benefits is computed in a two-step process. First, provisional income is computed using the following calculation. In general, provisional income will be adjusted gross income (AGI) plus tax-exempt interest and one-half of Social Security benefits as follows:

Adjusted gross income

Tax-exempt interest

50% of Social Security benefits

Less adjustments for adjusted gross income

Provisional income

After determining provisional income, the next step is to use Exhibit I to determine how much of the Social Security benefit is to be included in taxable income.

If provisional income is less than $25,000 ($32,000 for married filing jointly), none of the Social Security benefits (SSB) will be taxable. However, any increase in income that raises provisional income over this limit will result in inclusion of Social Security benefits in taxable income. Note that the provisional income calculation above includes tax-exempt interest and 50% of Social Security benefits. If provisional income is greater than $25,000 ($32,000 for married filing jointly) but not over $34,000 ($44,000), then 50% of the excess provisional income will be taxable until 50% of Social Security benefits have been included. For those in this income range, each additional $100 of pre-Social Security income results in an additional $150 of taxable income and an additional $42 of tax (assuming the 28% marginal tax bracket). This represents an effective tax rate of 42% (1.5 x 28%) on that additional income. This rate would affect all decisions and strategies until 50% of Social Security benefits have been included in income.

When provisional income exceeds $34,000 ($44,000 for married filing jointly), 85% of the excess provisional income will be taxable until 85% of Social Security benefits have been included. For those in this income range, each additional $100 of pre-Social Security income results in an additional $185 of taxable income and an additional $51.80 of tax (again, assuming the 28% marginal tax bracket). This represents an effective tax rate of 51.8% (1.85 x 28%) on that additional income. This rate would affect all decisions and strategies until 85% of Social Security benefits have been included in income. At that point, the marginal rate would return to 28%.

Some Unique Effects of Social Security Inclusion

Unique effects of Social Security inclusion create some issues that should be considered in addition to changes in marginal tax rates. These issues include the following:

The apparent "break-ven" elements of incurring deductible interest costs to preserve or generate income can be defeated because of the inclusion of Social Security benefits in taxable income. …