Retirees Face New Rule on Income : 1993 Law Changes the Way Social Security is Taxed
Norbert E. Talbert is steaming mad. He is a man of modest means, but he’s being taxed like a millionaire. And he doesn’t like it.
“We have been double-crossed on Social Security. We have been double-crossed on municipal bond interest. And we have been doubled-crossed on the idea that we should live modestly and save so that we can take care of ourselves in our old age,” the 71-year-old retiree fumes.
What set Talbert off is a 1993 tax law that will kick roughly 5.5 million middle-income Social Security recipients into the nation’s loftiest federal tax bracket for the first time this year.
Starting in 1994, single Social Security recipients who earn more than $34,000 and married couples with more than $44,000 in income get taxed at roughly a 42% marginal rate, says Ken Andersen, tax partner at the national accounting firm of Arthur Andersen & Co. The top marginal rate for millionaires is 39.6%.
The new tax rules dramatically boost the marginal tax rate--the rate you pay on every additional dollar over a threshold amount--because every dollar earned over the threshold pushes more Social Security income into the taxable column.
The actual amount of tax is tough to calculate, however, mainly because there are now three levels of taxation for Social Security income. And there are three different ways to calculate your liability.
You choose the calculation that comes up with the lowest tax obligation. Congress did that to reduce the hit on people who were just slightly over the new Social Security tax thresholds. In any case, the result is that you have to fill out an 18-line work sheet to determine your actual liability.
There are a handful of strategies retirees can use to reduce the hit, but they are aggressive, often onerous and largely irreversible. And, to complicate matters, some Republican members of Congress want to return to previous ways of deciding how much Social Security is subject to income, which puts these retirees in a sort of Catch-22.
Tax-saving strategies that may seem logical this year could look crazy in 1995 if the tax is indeed eliminated. Some retirees say they have little choice but to pay the tax--and live more simply as a result.
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“What this means to me is I am not going to be able to do something,” says Joseph Koukol, a Los Angeles area retiree. The new Social Security tax will cost Koukol roughly $2,000, he says. “I won’t starve, but it probably means I won’t be able to take a vacation.”
What exactly is this tax that’s causing retirees such consternation? It is a levy specifically on Social Security income.
Until recently, Social Security income was 50% taxable if you had significant amounts of other income.
The 50% figure had been justified for many years because, at least in theory, retirees were simply paying tax on the 50% of the contributions that had never been subject to tax before. Workers pay income tax on earnings that go into the Social Security system, but companies--which provide half of each worker’s Social Security contributions--do not.
Nonetheless, if you don’t make too much money, you’re not taxed. The government leaves benefits untouched for singles earning less than $25,000 and couples earning less than $32,000.
But, in a revenue-raising move last year, Congress decided to make Social Security benefits 85%-taxable for certain “high-income” retirees. Congress defined “high-income” as above $150,000 for non-retired married couples but at $44,000 for retirees.
Some Social Security recipients maintain that disparity is hardly fair. Although a retired person without a pension would have to have more than half a million dollars stashed away to produce that kind of investment income, a good pension could easily throw an otherwise modestly retired worker into that range.
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They also argue that subjecting more than 50% of the benefit to taxation affects the half of Social Security that has been taxed before. Federal income taxes are based on your gross earnings, before Social Security taxes are taken out. That means you pay state and federal income taxes on the amount withheld and sent into the Social Security system. If you also pay tax on that money when you start receiving the benefits, the same dollars are getting taxed twice.
What’s worse is there are few ways to plan around the Social Security tax. But millionaires--and virtually all individuals other than retirees--have lots of tax shelters at their disposal.
For instance, most taxpayers can enjoy tax-free earnings if they invest in municipal bonds. Not so for middle-income retirees. So-called “tax-exempt” income must be added into the calculation when determining how much of a retiree’s Social Security income is taxable. It may be coming through the back door, but that effectively makes municipal bond interest taxable for anyone who earns more than the threshold amounts.
Another way to avoid taxes is to contribute to retirement plans. But few retirees have much earned income, so they can’t.
Rich Americans can get breaks by investing in tax shelters and growth stocks that don’t pay regular income. But most retirees are living on their investment income. These investments simply force them to make due with less--a highly unattractive tax strategy.
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How can a retiree battle the Social Security tax? There’s really only one strategy that can substantially reduce the hit. It only works for married couples and it may violate personal and religious ethics.
“They can get divorced and live in sin,” says Nancy Anderson, manger of special tax projects at H&R; Block in Kansas City.
Consider what happens to a retired couple who earn $60,000 between them, including $12,000 in Social Security benefits.
Thanks to the new law, $10,200 of their Social Security income is taxable versus $6,000 in the previous law. Assuming they pay an effective rate of 28% on that income, the tax on their Social Security earnings amounts to $2,856. (Under previous law, the tax bite on their Social Security income would amount to $1,680--$1,176 less.)
Now consider what happens if this couple decides to legally divorce and divide their income exactly in two. For example’s sake, we’ll also assume they both receive the same Social Security benefits--$6,000 each.
The tax on their Social Security income dives to $280 per person, or $560 combined. That’s a whopping $2,296 savings.
Additionally, homeowners age 55 and over get an additional tax break that’s multiplied by two for those who divorce but continue to reside in the same home and claim it as their primary residence.
Specifically, if this couple sold their home when they were married, they would be able to exclude $125,000 in gains from tax. If they sold their home when they were legally divorced, they’d be able to exclude $250,000 from tax--$125,000 each, says Philip J. Holthouse, partner at Holthouse Carlin & Van Trigt in Los Angeles. With the capital gains tax at 28%, together that saves them $70,000 in federal taxes.
The one problem with divorcing for tax purposes is it’s fairly irreversible. Although your marital status at the end of the year is what matters for the tax man, if you divorce in December and remarry in January, the IRS will deem the divorce a sham and slap you with taxes and penalties.
Additionally, it forces couples to take a hard look at their estate plans. While divorce can aid some estate planning techniques, those who want to leave their assets to a former spouse need to say so in a will or a living trust. Otherwise, your estate is divvied up according to state intestacy laws when you die, which don’t grant ex-wives and ex-husbands much clout.
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Subject to Tax
How do you determine how much of your Social Security earnings are taxable? It’s not easy. It ranges from nothing to 85%. To figure it to the penny, you must fill out an 18-line work sheet--as well as a 1040 or 1040A tax form. The key factors are marital status and income. This chart can help you make a simple guess. Amount of a $10,000 annual Social Security benefit subject to tax:
Amount of Social Security taxable: Base Income Single Joint $25,000 none none $34,000 $4,500 $1,000 $38,000 $7,900 $3,000 $44,000 $8,500 $5,000 $50,000 $8,500 $8,500
Source: Ernst & Young
