Costly Tax Traps Can Ensnare Recipients of Social Security Benefits
Social Security seems like a nice reward for a life of hard work--until the first time a newly minted retiree has to file a tax return.
Receiving a Social Security check can vastly complicate filing a tax return, and it can subject recipients to unexpected traps that significantly boost their federal income taxes.
Just ask Tom McCarthy, a retiree from Chino Hills. The 76-year-old took a part-time job one year, thinking he could supplement his income. However, he didn’t fully account for the impact on his tax bill. He knew that he’d have to pay tax on his wages, but he didn’t realize that his earnings would cause 85% of his Social Security benefits to become taxable.
The misstep left him owing $6,000 the following April. He had to tap retirement savings to pay the tax bill, which boosted his taxable income the following year too.
“It’s painful,” McCarthy said. “I have never complained about paying taxes before. But here I am with a very moderate income, and I am literally being taxed to death. My individual retirement account is being depleted just to pay income taxes.”
Because of a change in Social Security laws, the number of first-time recipients jumped by about 300,000 to almost 2 million in 2000, ensuring that more people than ever will grapple with Social Security taxes this filing season.
If you’re in that group, here are several things you should know:
* If your annual retirement income exceeds $25,000 (for single filers) or $32,000 (for married filers), up to half your Social Security benefits will be subject to income taxes. Retirement income includes monthly Social Security payments plus any other income you receive, including wages, distributions from a defined-contribution pension plan such as a 401(k) and payments from a defined-benefit plan such as a corporate pension.
Theoretically, what you’re being taxed on is the money your employer contributed to the Social Security system. (Unlike your contributions, which came from wages that were already subject to income tax, your employer got a deduction for making Social Security contributions on your behalf. When instituting this tax, the government argued that this never-taxed income ought to be taxed when it was received.)
* If your retirement income exceeds $34,000 (single) or $44,000 (married), you will pay tax on up to 85% of your Social Security benefits, the result of a law passed in 1993. At the time, legislators called this a tax on “wealthy” retirees. The threshold levels that determine when a retiree is wealthy enough to be subject to the 85% tax were not adjusted for inflation, so comparatively poorer retirees are hit by this tax each year.
McCarthy was clipped by this provision when a $1,000 distribution from a retirement plan cost him $462 in income tax.
“I wonder how many zillionaires pay 46.2% on any portion of their income,” he said.
* Figuring what percentage of Social Security benefits is taxable requires filling out an 18-line work sheet, which is heavily cross-referenced to the 1040 tax form and requires numerous calculations. McCarthy, a former engineer who tutors students in high school algebra, said he gave up on filling out the work sheet himself and bought a $50 tax computer program to do it for him--a strategy that many tax accountants recommend.
* Once you begin receiving Social Security income, previously nontaxable income, such as interest earned on municipal bonds, becomes taxable through a back door. Specifically, it is added into the calculation when determining how much of your Social Security is subject to tax, pushing more of your Social Security income into the taxable column. If you owned municipal bonds before you retired, consider selling them. If you were considering buying some in retirement, don’t.
A retiree is often better off owning taxable bonds, such as those sold by the federal government. They generally pay higher interest rates than municipal bonds. Their after-tax return is higher too, if the municipal bonds’ tax advantage is neutralized by the “Social Security trap.”
* If you receive a lump-sum payment from Social Security that includes payment for benefits earned in a previous year, you can either consider the entire amount received and taxable in 2000 or you can choose to have the amount attributed to previous-year benefits allocated to that year’s return. Naturally, that requires more fancy tax work.
You don’t have to amend your previous year’s return to do this, according to “Taxes for Dummies,” by Eric Tyson and David Silverman (Hungry Minds Inc., 2000). Instead, figure out what portion of the lump sum would have been taxable had it been received in the previous year--presumably by filling out another Social Security work sheet with that year’s income. Then add the result to your income during the current tax year.
When would it make sense to go to all that trouble? When you earned significantly less in the previous year than the current one. That would cause less of the lump sum to be subject to income tax, which could save you hundreds of dollars. Need more detail? Consult “Taxes for Dummies,” or a professional tax advisor.
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Social Climbing
The number of first-time Social Security recipients jumped sharply last year after the law was changed to allow many working 65-to-70-year-olds to collect payments regardless of their income.
Recipients of Social Security retirement benefits, in millions
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First-time Total 1996 1.6 26.9 1997 1.7 27.3 1998 1.6 27.5 1999 1.7 27.8 2000* 2.0 28.3
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* Through June 2000
Source: Social Security Administration
