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Currently growth investor with plans to move more into dividend stocks as I get closer to retirement.
  • Social Security Benefits and the 55.5% Tax Bracket 3 comments
    Nov 9, 2011 7:53 PM
    Every year there is a lot of press regarding the need for Congress to step in and provide an income adjustment for the Alternative Minimum Tax (NYSE:AMT). As average incomes increase, more taxpayers become subject to this tax since it is not automatically indexed for inflation. The AMT in its present form was enacted under Reagan in 1982 when it was changed from an add-on tax to a parallel tax where the higher of the regular tax or the AMT is assessed.
    Another tax which doesn’t get the press it deserves is the tax on Social Security benefits. This tax, also enacted under Reagan, was designed to tax the Social Security benefits of higher-income taxpayers with household incomes above $25,000 for singles and $32,000 for couples.
    In computing a person’s retirement benefit, the Social Security Administration uses a National Average Wage Index (  According to that index, the national average wage in 1983 was $15,239.24. In 1983, household income of $25,000 was considered “higher income” and, therefore, those taxpayers should be "giving back" some of their benefits. In 2010, the national average wage was $41,673.83. That works out to an average annual increase of nearly 3.8% from the 1983 level. But the tax on Social Security benefits for household income thresholds of $25,000 for singles and $32,000 for couples remains in effect.

    A Brief Primer on how Social Security benefits are taxed

    To determine how much Social Security benefits should be taxed, it is first necessary to determine “Provisional Income”. Provisional income is

    + Gross Income
    + Tax-free interest
    + 50% of Social Security benefits.
    - Adjustments to income
    = Provisional Income

    Adjustments to income referred to above are some of the adjustments from the bottom of the Form 1040. Most non-working retirees have no adjustments.

    For every $100 that provisional income exceeds $25,000 for singles and $32,000 for couples, $50 is added to taxable income.  This continues until provisional income exceeds the upper household income limit which is $34,000 for singles and $44,000 for couples.  For every $100 above these upper limits, $85 is added to taxable income.  This continues until 85% of Social Security benefits have been added to taxable income.

    In other words, for every $100 of provisional income within the range of $25,000 to $34,000 for singles and $32,000 to $44,000 for couples, taxable income is increased by $150.  After provisional income exceeds the upper limits of these ranges, taxable income is increased by $185 for every $100 of provisional income until 85% of total Social Security benefits have been included in taxable income.

    Tax Rate definitions

    It is important to understand the following definitions of tax rates.

    Marginal Tax Rate – Taxable Income
    This tax rate is the one most commonly referred to by the media.  It refers to the IRS tax table rates.  The current tax code has six rates: 10%, 15%, 25%, 28%, 33%, and 35%.  Taxpayers “graduate” to the following tax bracket as taxable income increases.  Each new taxable dollar is taxed in a bracket until total taxable dollars step up to the next bracket.  For example, if the tax on taxable income of $20,000 is $3,000 and the tax on $30,000 is $4,500, then the marginal tax rate would be the difference in the tax (4,500 – 3,000 = 1,500) divided by the difference in the income (30,000 – 20,000 = 10,000) or 15%.

    Marginal Tax Rate – Total Income
    This rate is essentially the same as Marginal Tax Rate – Taxable Income except that its denominator is the change in “Total Income” rather than “Taxable Income”.  This distinction is extremely important. Social Security benefits are included in Total income but not Taxable income until the lower limit of provisional income is exceeded.

    Effective Tax Rate

    The effective tax rate is ordinarily actual income tax paid divided by net taxable income.  The effective tax rate referred to here will be Actual income tax paid divided by
    Total income rather than taxable income.  Since Total income is higher than Taxable income, the ratio will be smaller.  Total income is more useful  here since it ignores standard/itemized deductions, personal exemptions and other non-tax deductions. It provides a better picture of actual tax liability as a percentage of all sources of income.
    The scale along the bottom of each graph shown below represents total income from all sources including the full amount of Social Security benefits, qualified dividends, capital gains and tax-free interest.  All taxes are calculated using rates from the 2011 tax rate schedule.

    The following graph illustrates the effective vs. marginal tax rates of ordinary income with no Social Security benefits or other non-taxable income for an over age 65 single claiming the standard deduction and one exemption.

    The effective rate falls below the marginal rates because the next higher tax bracket does not capture dollars from earlier, lower tax brackets and "catch them up" to the next bracket.  Both marginal rates are the same and overlap on this graph, since no Social Security benefits are included in total income.
    Adding Social Security Income to Ordinary Income
    The next graph displays a taxpayer who receives $18,000 per year Social Security benefits.  The increasing income shown along the bottom of the graph is our taxpayer at different levels of ordinary income such as pensions, Required Minimum Distributions (NYSE:RMD) and interest. Social Security benefits are included in total income, but since they are fixed annually, they do not contribute to increasing income levels along the x-axis.

    Notice the blue line for Marginal Rate - Total Income is now much higher than the red line for Marginal Rate - Taxable Income. The blue line is higher for as long as it takes to capture 85% of Social Security benefits into taxable income after which it will fall to the 25% tax bracket.
    The first increase occurs when the lower provisional income limit of $25,000 is exceeded. The "real" tax rate for that level of income is 10% for this taxpayer as shown here:

    + 25,000  Provisional income
    -   9,000   50% of Social Security benefits
    -   7,250   Standard deduction age 65 & older
    -   3,700   Personal exemption
    =  5,050  Taxable income (10% tax bracket)

    The addition of 50% of Social Security benefits causes our taxpayer to be taxed on $1.50 for every dollar of income which increases the marginal tax rate from 10% to 15%. The total income blue line increases to 15% while the taxable income red line stays at 10%.
    When “real” taxable income exceeds $8,500 our taxpayer will be in the 15% tax bracket.  The total income marginal rate will change to 22.5%. The taxable income red line increases from 10% to 15% and the total income blue line increases to 22.5% (1.5 times 15%).

    The next increase occurs when provisional income exceeds $34,000 (the upper limit of the provisional income range for a single taxpayer). Social Security benefits above this limit are now included in taxable income at the rate of $0.85 per dollar of taxable income. The taxable income red line remains at 15% while the total income blue line increases to 27.75% (1.85 times 15%).
    After taxable income passes into the 25% tax bracket (for 2011 this bracket begins at $34,500), the taxable income red line shifts from 15% to 25% while the total income blue line increases to 46.25% (1.85 times 25%).  It remains there until 85% of Social Security benefits have been included in taxable income.
    Taxpayers receiving higher Social Security benefits will remain in the 46.25% tax bracket much longer since it will take longer to capture 85% of the benefits. In the example above, the taxpayer receives $18,000 per year from Social Security and completes the trip through “Social Security Purgatory” at total income of $55,700.  A taxpayer receiving $22,000 Social Security benefits would remain in the 46.25% tax bracket until total income reaches $61,700.  Beneficiaries receiving lower benefits will not be taxed more than 27.75% since 85% of their benefits will be included into taxable income while still in the 15% tax bracket.
    Adding Social Security Income to Qualified Dividend Income

    This next graph uses the same taxpayer but changes the source of income from ordinary income to qualified dividends. The increasing income shown on the x-axis of the graph is our taxpayer at different levels of income from qualified dividends and includes the fixed annual Social Security benefit of $18,000.

    The tax calculations get very complicated here. Initially, there is no tax on the qualified dividends. Income becomes taxable when the taxable portion of Social Security benefits exceeds the standard deduction plus personal exemption (7,250 + 3,700). This initial rate on total income is 8.5% shown on the blue line in the graph above. After taxable income (qualified dividends plus taxable portion Social Security benefits) reaches the 15% tax bracket, then 15% tax is applied to qualified dividends. At this point, the total income blue line rises to 36.25% where it remains until 85% of Social Security benefits have been taxed. Rather than try to explain "how" the tax is computed, focus on the graphical result. Whenever the blue line is higher than the red line is when additional tax is being assessed on Social Security benefits.

    The Dreaded 55.5% Tax Bracket

    It is hard to believe, but there really is a marginal rate of 55.5%. Let’s visit our fictional taxpayer again. This time he receives an annual Social Security benefit of $18,000 and qualified dividends of $10,000.  The amount on the x-axis will vary based on other ordinary income such as Required Minimum Distribution (RMD) or pension benefits. 

    First, focus on the marginal rate - taxable income red line. Notice the jump from 15% to 30%. Qualified dividends, which were tax free in the 10% and 15% tax brackets, become taxable at 15% once taxable income enters the 25% tax bracket. Two things are happening; taxable income increases and is taxed at 15%; plus previously untaxed qualified dividend dollars are now being taxed at 15% and that tax is added to ordinary tax. The IRS is running back to collect tax on water which has already passed under the bridge. The combination of both 15% rates equals a marginal rate of 30%. The marginal rate continues at 30% until all dividends have been taxed after which the marginal rate – taxable income drops to 25%.
    Social Security benefits layer another tax on top of ordinary and qualified dividends taxes. The result is a multiplier of 1.5 or 1.85. When provisional income is between $25,000 to $34,000 for singles and $32,000 to $44,000 for couples, the multiplier is 1.5. Tax on provisional income above the upper limits is multiplied by 1.85. The 30% tax on the combination of ordinary income and qualified dividends is multiplied by 1.85 to get 55.5%.
    This is not some numbers game – it is a real tax. Assume our taxpayer had total income of $52,000 and decided to withdraw an additional $3,000 in December to cover holiday spending bringing his total income to $55,000. The withdrawal would cost an additional $1,665 income tax - a whopping 55.5%! Ouch!
    A more common scenario is a taxpayer whose Social Security benefits, investment income and pension income are in the range of $35,000 to $40,000. He turns 70 ½ and RMD forces him to withdraw from his qualified plan – right into a 22.5% or 27.75% tax rate. 
    Tax Planning

    Many taxpayers are above the upper limits of Social Security purgatory and no amount of tax planning can change that. They pay the penalty without realizing it happened.

    For taxpayers with smaller incomes, some planning opportunities exist. Additional distributions can be withdrawn from a qualified plan at lower tax rates. Looking at the graph above, if current total income is $40,000, this taxpayer could withdraw an additional $3,000 at a marginal rate of 15% before hitting the 27.75% marginal rate.

    If a retiree expects to live significantly past age 80, delaying Social Security benefits until age 70 will provide the highest lifetime benefit. The retiree could retire at 66 and take distributions from a qualified retirement plan while waiting until age 70 to start taking Social Security. Then the RMD's after age 70 ½ will be smaller and possibly avoid the additional tax.

    It is nearly impossible for the average taxpayer (and, in many cases, the average tax preparer!) to wrap their mind around the incredible complexity of tax law. Often, Congress will pass legislation with good intentions but codifying that legislation into enforceable tax law creates unsatisfactory consequences as shown above. Something is wrong when legislators do battle over creating a surtax for the wealthy while ignoring a surtax which our seniors have paid for nearly 30 years.  And with no inflation adjustment, each year it affects ever increasing numbers of retirees.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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Comments (3)
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  • Dennis Anderson
    , contributor
    Comments (402) | Send Message
    Larry; Discovered your blog via your comments on articles. Thanks for a very informative article. I am 64, wife 63, and the older we get the more I discover what I don't know about SS. I saved your article, because it's going to take me awhile to absorb. I've always done my own taxes,but do you have any suggestions on locating a good local CPA/tax preparer who understands planning as well as filing for dividend income, capital gains from the sale of a business and options trading income?


    nothingvery clever
    19 Nov 2011, 04:54 PM Reply Like
  • Bering Hill
    , contributor
    Comments (28) | Send Message
    Author’s reply » Thanks for your comment. I have replied privately by sending you a message due to the personal nature of your question.
    You said "it's going to take me awhile to absorb" - I actually got a similar response from a CPA collegue here in town and from my son who practices in another state. Frankly, as I said in the article, most taxpayers pass thru Social Security purgatory without realizing it. And I suspect most professional tax preparers help clients who have already passed thru. That's why most I have talked with have no idea what is happening. The "lower" income retiree is the one most likely getting hurt by this because their total income puts them right in the middle of it.
    19 Nov 2011, 08:14 PM Reply Like
  • David Crosetti
    , contributor
    Comments (13646) | Send Message
    For a guy who says he doesn't do Trust income tax returns, I find that your thought process is absolutely brilliant. Nice article, Larry. I will also spend some time absorbing this. My assumptions on SS have been exposed to me as incorrect! Think I will divorce my younger wife, draw only social security income (give her everything else) and continue to live with her. How's that? Just kidding.


    16 Dec 2011, 10:27 AM Reply Like
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