A Twist on Taxing Social Security
QUESTION: Your comments about a month ago on the rationale behind the formula for calculating which Social Security benefits are now taxable was interesting and useful. Can you elaborate a bit to explain why married taxpayers who file separate tax returns are given no break whatsoever and thus automatically are taxed on half of their Social Security benefits?--R. C. S.
ANSWER: Congress wanted to discourage married couples from filing separate tax returns as a ploy to escape taxation of their Social Security benefits. So the lawmakers decided against giving married taxpayers filing separately the same allowance--$25,000--granted single taxpayers and taxpayers who are married but not living together.
Here’s how that might work. Say the wife of a couple has Social Security benefits of $5,000 and other income totaling $20,000 and that her husband’s Social Security benefits are $3,000 and his other income $12,000. If they filed jointly, they would determine how much of their combined benefits are taxable by halving their total benefits, adding that figure to their combined income and then comparing the final result with this allowance we’ve been discussing. The couple would be taxed on: 1) half of any amount that remains after the allowance is deducted or, 2) half of their benefits, whichever figure is smaller.
(Actually, the exact wording of the formula is this: You are taxed on half of the amount by which the sum of your modified adjusted gross income plus one-half of your net Social Security benefits exceeds the base amount for your filing status. We have abbreviated the terms here to income and benefits for simplicity’s sake.)
So this couple would be taxed on the lesser of $4,000 (half of their benefits) or half of what remains when the $32,000 allowance for married couples filing jointly is subtracted from the sum of combined income ($32,000) and half of the combined benefits ($4,000). Since the resulting amount ($2,000) is less than $4,000, this couple would be taxed on $2,000 of their Social Security benefits.
If they instead filed separate returns and the allowance was set at the $25,000 going rate for singles and married couples not living together, neither individual would pay any taxes on their benefits.
As the law reads now, with a zero allowance for married couples living together and filing separate returns, these taxpayers would be taxed on half of their benefits because that figure is far smaller than the amount each would arrive at via the formula.
Any reasonable individual might now ask why the lawmakers didn’t simply provide a smaller allowance for these married taxpayers filing separately--say, half of the $32,000 allowance granted married couples filing jointly, or $16,000. After all, there are married couples who file separate returns for legitimate reasons. The only answer we’ve been able to come up with is a most unsatisfactory one: Nobody seems to know.
Q: Your replies to questions about distributions from IRAs have been very helpful. But I have yet to see anyone address whether a minimum amount of money must be withdrawn from each IRA you have once you reach age 70 1/2 or whether all of your IRAs can be grouped together and a large enough withdrawal made from just one. Which is it?--J. D. G.
A: It probably won’t surprise you to hear that it has to be done the more complicated way. You have to take out the minimum amount from each account. That doesn’t mean you have to establish identical withdrawal procedures for all of them. You could, for example, cash in some of them and pay the tax, buy an annuity with others and establish a pay-out plan for the rest. But each one must be treated separately.
The formula for determining how much must be withdrawn each year is based on your life expectancy or the combined life expectancies of you and your beneficiary, and is rather complex. You will need to get a copy of the IRS tables with this information or consult a financial adviser or both. Miscalculate and you could wind up paying a stiff penalty.
Another thing to keep in mind is that some IRA sponsors have more restrictive withdrawal rules and steeper penalties than the IRS. They have the right to waive premature withdrawal penalties for fixed-term investments for persons aged 59 1/2 or older. But they are not required to do so, and many don’t.
So it isn’t out of the question that you could finish all of your calculations, go to withdraw the appropriate amounts from your IRAs and be told by one or more of the sponsors that you can’t withdraw any of the money until the savings instrument in which it is invested matures--or that you will be seriously penalized for doing so. To prevent such a nightmare from occurring, make sure you have your pay-out plan established and everything squared away with the plan sponsors well in advance of the deadline--April 1 after the year in which you reach age 70 1/2.
Q: You mentioned in a recent column that IRA participants have the right to physically withdraw their money from an IRA, without incurring penalties, one time a year. Will you clarify whether you mean once per calendar year or once every 365 days?--C. C.
A: At least one full year must elapse between roll-overs from one IRA to another in order for them to be treated as tax-free moves. So you aren’t permitted to close an IRA this month, establish another IRA with that money within 60 days and then undertake another roll-over in, say, March of next year. It isn’t good enough for the roll-overs to occur in different calendar years; they have to occur a full year apart.
If you find yourself in a position where you have to do something like this, simply ask the plan sponsor to transfer the money to a different IRA of your choosing. By law, the sponsor has to do it for you, even if you are moving your money to a different institution. (You will find that a transfer may take longer than seems necessary. But keep in mind that the institution sponsoring the IRA is in no hurry to help you move the account to a different institution.) There are no limits on the number of times in a single year you can do a transfer. The restrictions only apply when you actually take possession of the money.
Debra Whitefield cannot answer mail individually but will respond in this column to financial questions of general interest. Do not telephone. Write to Money Talk, Business Section, The Times, Times Mirror Square, Los Angeles 90053.
