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By A. Lee Gurley III and
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 mid-income 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 range--an area not uncommon for today's retirees. Married taxpayers with income levels in the $32,000 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.
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 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:
After determining provisional income, the next step is to use Exhibit 1 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
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%.
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 following are examples to show how some of these elements would work for a married couple filing jointly, both 65 years old and receiving $22,000 in Social Security benefits. The examples assume the tax calculation as shown in the first column of Exhibit 2.
Liquidate Investment to Pay Off Mortgage. A taxpayer who itemizes deductions would generally consider retaining an investment yielding seven percent while incurring home mortgage interest of seven percent to be a break-even situation. However, such an individual in the phase-in range for Social Security could reduce taxable income by using investment funds to pay off the mortgage. In the 85% range, the tax savings could be as much as 23.8% (85% of 28%) of the reduced interest income. For a couple using the standard deduction, the savings could be as much as 51.8% (1.85 x 28%).
In our example, paying off the mortgage would reduce dividend and interest income by $3,000. This would cause a reduction of taxable Social Security income of $2,550 (85% of $3,000) resulting in a total tax savings of $1,554.
If the mortgage rate exceeds the rate of return on the liquidated investment, the overall savings would be greater. The tax saving in this example could be less if the taxpayers had been itemizing deductions before paying off the mortgage but used the standard deduction after reducing home-mortgage interest.
Contribution of Short-Term Capital Property. When an individual contributes short-term capital gain property to charity, the deduction is the basis of the property, but the gain is not taxed. Given a choice of contributing stock with a fair-market value of $3,000 (basis of $2,000) or selling the stock for $3,000 and contributing cash of $3,000, a savings of up to $238 ($1,000 x 85% x 28%) could result from an itemizing taxpayer contributing the stock. If the taxpayer does not itemize deductions, the potential savings grows to $518 ($1,000 x 1.85 x 28%).
The savings would be the same if long-term capital gain property had been used to make the contribution. However, itemizing taxpayers would reap greater benefits from using long-term capital gain property instead of short-term capital gain property, since the deduction can be fair-market value for contributions of long-term capital gain property.
IRA Contribution. A Social Security recipient who also has earned income can contribute up to $2,000 ($4,000 if married filing jointly) to an IRA. Income taxation of Social Security benefits can make IRA contributions more attractive. IRA contributions of $4,000 could reduce tax by up to $2,072 ($4,000 x 1.85 x 28%).
Tax savings can also result from either bunching or smoothing of income. Timing of income can be accomplished through timing of withdrawals from individual retirement accounts or other retirement savings plans that offer such flexibility. In addition, individuals may time the receipt of salary and wage payments or realization of capital gains and losses.
If provisional income is close to the point at which 85% of benefits are taxable, tax savings can result from periodic bunching of income. Once the 85% taxability point is reached, additional income does not result in the inclusion of additional Social Security benefits. Consequently, bunching of income in such years can reduce the amount of taxable Social Security benefits. This could result in savings of 23.8% (28% x 85%) of the income shifted. Similar strategies can also produce savings for those in the range where 50% of benefits are included in income but the phase-in range for 85% inclusion has not yet been reached.
Exhibit 3 contains an example of the effect of income bunching. The first two columns show the normal receipt of IRA distributions. The last two indicate a shift of $10,000 from the second to the first year. The shifting of income results in a tax savings of $837 as a result of the reduction in Social Security income subject to tax. The first-year increase in benefits taxed ($800) is capped at the maximum 85% level while a reduction of $8,500 flows through in the second year.
If provisional income is close to the level where benefits are not taxable ($32,000 for married filing jointly), avoiding extreme fluctuations in income can result in tax savings. Fluctuations could result in taxation of Social Security in high-income years that could be avoided by income leveling. In addition, such individuals may be moving income into the 28% marginal tax bracket that would have been taxed at 15% with leveling.
The Taxpayer Relief Act of 1997 decreased the top capital gains tax rate. While the lower rates are attractive, those receiving Social Security benefits should always consider that the realization of a one dollar gain (regardless of the applicable tax rate) may result in the inclusion of as much as 85 cents in taxable income due to the inclusion of Social Security benefits. In addition, this additional income is taxed at the "normal" rate.
The new Roth IRA provides valuable planning opportunities for those approaching retirement. Contributions to a Roth IRA can begin in 1998 but will not be deductible from income like traditional IRAs. The benefit from such an arrangement is that appreciation and withdrawals from Roth IRAs after age 59 1/2 will be tax free. Consideration should also be given to rolling existing IRAs into a Roth IRA. Tax will be due on the conversion, but later withdrawals will not be taxable. The Roth IRA may be ideal for providing retirement income that will not increase the taxation of Social Security benefits.
In addition, taxpayers approaching retirement may find it advisable to accumulate some nonsheltered savings. These types of investments could be used during retirement years to provide for some portion of needed resources without the necessity of recognizing taxable income. These savings could be extremely valuable to planning around the inclusion of Social Security benefits in taxable income.
One area that is out of the scope of this discussion is that the taxpayer reaching limits of earned income also faces the potential reduction of Social Security benefits. When combined with the potential for leverage of additional income taxes triggered by higher income levels, some instances of taxpayers actually having a net negative cash flow can result from these combined effects. *
A. Lee Gurley III, PhD, CPA, and Lloyd "Pat" Seaton, PhD, CPA are assistant professors of accounting at the University of Wyoming.
Editor:
Contributing Editors:
John F. Burke, CPA
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