Americans often dream about a simplification of the Byzantine Internal Revenue Code, only to awaken and find the tax laws becoming more complicated.
The rules for Social Security benefits are especially convoluted and confusing. Although most Social Security recipients escape income taxes completely on all of their benefits, middle- and upper-income level retirees have to count up to 85% of their benefits as reportable income.
Taxes are triggered for Social Security recipients when their MAGI exceeds specified amounts. MAGI is an acronym for modified adjusted gross income, which in most instances is essentially the same amount as adjusted gross income.
To calculate whether MAGI surpasses the tax-triggering thresholds, retirees must consider income from various sources such as: salaries, pensions, dividends, capital gains, rents, Roth conversions (money moved out of traditional IRAs and into Roth accounts), and required minimum distributionsstarting at age 70½ from traditional IRAs, 401(k)s, and other retirement plans.
The wide-ranging MAGI tally for Social Security benefits also includes whatever retirees receive as tax-exempt interest from municipal bonds (obligations issued by state and local governments) or from muni bond funds, as well as 50% of Social Security benefits. Table 1 shows how to calculate MAGI.
A Social Security Benefits (annual total)
B Calculate Half of Line A
C Adjusted Gross Income (pensions, wages, dividends, Roth conversions, etc.)
D Tax-Exempt Interest Income (e.g., interest from municipal bonds)
E Add Lines B, C, D to Determine MAGI
Take, for example, a married couple who have Social Security benefits of $28,000, adjusted gross income of $31,000, and tax-exempt interest of $5,000 for a total of $64,000. Their MAGI is $50,000 (see Table 2).
A Social Security Benefits $28,000
B Half of Social Security Benefits $14,000
C Adjusted Gross Income $31,000
D Tax-Exempt Interest Income $5,000
E MAGI (total of lines B, C and D) $50,000
The Internal Revenue Service uses a three-tiered threshold to determine the size of its bite on benefits. If MAGI is less than $25,000 for single taxpayers ($32,000 for married couples filing jointly), then Social Security benefits are not taxed. If MAGI is between $25,000 and $34,000 for singles (between $32,000 and $44,000 for couples), up to 50% of Social Security benefits are taxed. And if MAGI tops $34,000 for singles and $44,000 for joint filers, up to 85% of benefits are taxed (Table 3). Special rules apply to married couples who file separate returns. More on that later.
Modified Adjusted Gross IncomeBenefits Taxed__
< $25,000 Single ($32,000 Married) None Taxed
$25,000 to $34,000 Single ($32,000 to $44,000 Married) Up to 50%
> $34,000 Single ($44,000 Married) Up to 85%
The MAGI numbers are significant for those receiving Social Security benefits because the greater the incomes they derive from sources other than Social Security, the greater the portions of their benefits that become taxable. Once beyond the top threshold, each additional $100 of income from pensions or investments can cause an additional $85 of benefits to be taxed.
Suppose Patrick and Nadine Vennebush have combined salaries and pensions of $100,000 per year. They are able to claim enough deductions (dependency exemptions, real estate taxes, mortgage interest, etc.) to fall into the 15% federal tax bracket. (For couples in 2010, this bracket covers taxable income between $16,750 and $68,000.) Their MAGI puts them slightly below the threshold for the highest MAGI tier.
The Vennebushes need additional funds to cover unanticipated expenses. Without considering the tax consequences beforehand, Patrick and Nadine opt to take $3,000 from a traditional IRA, a withdrawal that is in addition to any required minimum distributionthey conceivably might have taken. The $3,000 pushes their total income above the threshold for the highest MAGI tier (they were below the threshold prior to the withdrawal), thereby bumping another $2,550 (85% of $3,000) of benefits into taxable terrain.
That means the $3,000 withdrawal increases their income taxes by $833: the sum of $450 (15% of the $3,000 IRA withdrawal), plus $383 (15% of the $2,550 worth of Social Security benefits). Consequently, their effective tax rate on the withdrawal nearly doubles to 27.8%. Worse still, the federal tab is before any applicable state income taxes.
Most of the time, I encourage investors like the Vennebushes to defer taking distributions from their retirement plans for as long as possible, using only the RMD, whenever feasible, as a way of delaying the inevitable tax bite. This tactic becomes even more advantageous when there is the potential for higher taxes on a portion of Social Security benefits.
A savvier strategy that leaves MAGI unchanged would be for the Vennebushes to take a non-taxable $3,000 from a place like a savings account and then repay the “loan.”
Alternatively, the couple could realize paper losses on investments in individual stocks, bonds or mutual fund shares to offset capital gains. They cannot offset capital losses against “qualifying dividends,” which is IRS lingo for dividends that are taxed at rates of 15% or 0%; it makes no difference that those rates are the same as those for capital gains.
What if the Vennebushes have no gains to offset or if losses exceed gains? They can use their losses to offset as much as $3,000 of ordinary income, such as salaries, business profits, pensions, and interest, thereby reducing MAGI.
What if losses aggregate more than $3,000? Not to worry. They can carry forward unused losses indefinitely to offset future income, should that prove necessary. But the couple’s planning can come undone if they ignore or are unaware of the rules for what the IRS characterizes as a wash sale. They forfeit a current deduction for their loss if they step back into the same or a “substantially identical” investment within a period that spans from 30 days before to 30 days after the sale, a transaction that is called a “wash sale.”
Yet another complication is a much-misunderstood restriction for couples who opt to file separate returns. The general rule is that their threshold for exemption from taxes drops from $32,000 to $0. To qualify for relief from the general rule, the spouses must not reside together at any time during the taxable year. Stated another way, a couple who lived together, even for just a day, and file separately are not allowed the base exemption amount of $25,000 each. All of their Social Security benefits count as reportable income.
This trap snared Thomas W. McAdams, a retired Army colonel. Tom and his wife Norma stayed married but lived apart: She lived in the home they owned in Boise, Idaho, while for many years he lived most of the time in Ninilchik, Alaska, and other locales far from Boise. The estranged spouses listed themselves on their 1040s as “married filing separately.”
The IRS computers bounced Tom’s return. During the audit, Tom inadvertently divulged that he stayed in Norma’s dwelling for more than 30 days during the year at issue, though he always slept in a separate bedroom. That admission led the U.S. Tax Court to agree with the IRS that Tom did not, as the law specifies, “live apart” from his wife “at all times during the taxable year.” The 2002 decision deconstructed living apart to only mean living in separate residences, not separate areas of the same residence. It held that his visits disqualified him for the $25,000 exemption. Hence, his Social Security benefits did not sidestep taxes.
A couple could avoid this if they divorced and then lived together out of wedlock. A beleaguered IRS readily concedes that as long as their unaltered arrangement remains unaltered, each spouse would be entitled to use the base amount of $25,000 for a single person.
The Tax Court’s analysis underscores that a married couple who live together and file separate returns must resign themselves to the forfeiture of their threshold. Consequently, why would it be worthwhile for retirees receiving benefits to consider skipping joint returns?
Actually, there are a number of sensible reasons. The biggest, from a monetary standpoint, is that submitting separate 1040s can lessen amounts lost to taxes. Take the not-uncommon situation where one spouse has a relatively modest adjusted gross income, AGI, and is able to claim sizable write-offs on Schedule A of the 1040 form for three categories of itemized deductions that are limited by a percentage of AGI. The possibilities are: uninsured medical expenses, allowable just for the part that exceeds 7.5% of AGI; uninsured casualty and theft losses, allowable only when such losses exceed $500 ($100 for 2008 and earlier years) for each casualty or theft, plus 10% of AGI, unless they occur in places determined to be disaster areas eligible for federal assistance; and miscellaneous expenses, such as fees for preparation of 1040 forms or advice on tax and investment strategies, allowable just for the portion above 2% of AGI. Claiming those kinds of expenditures on a separate return that reports less AGI than a joint return means that more of them become allowable.
It should be noted that signing a joint return makes each spouse responsible for the total tax liability on the return—and for any increase in that liability due to the other spouse’s underreporting of income or embellishment of deductions and credits. The law explicitly allows the government to keep both spouses tied to their old joint tax liabilities long after every other bond that joined them has been dissolved. The IRS could not care less that one spouse has since died or that the extra taxes are attributable to the deceased spouse’s business or income. Moreover, it is immaterial that a divorce decree specifies that one spouse assumes complete responsibility for previous joint returns.
Fortunately, the joint-liability regulations are not inflexible. Inserted into the Internal Revenue Code are several relief provisions that let individuals cleanly and permanently sever themselves from all tax wrongdoings of their former or estranged spouses. But establishing eligibility for relief frequently requires the high-priced help of tax professionals, expenditures that are avoidable by the submission of separate returns.
Because conversion income counts as reportable income, a Roth IRA conversion could increase MAGI by enough to cause otherwise tax-free Social Security benefits to become partially taxable. But as there are no taxes on subsequent Roth withdrawals, they will not expose benefits to taxation.
Put another way, you can incur taxes on Social Security benefits because of taxable transfers from traditional IRAs to Roth accounts, but not because of later Roth removals.
Moving money into tax-exempt investments can significantly lower the total tax bill for retirees, just as it does for others. But that maneuver will not diminish the taxes paid on Social Security benefits by retirees who also receive tax-exempt interest.
As mentioned earlier, tax-free interest must be added to funds received from pensions and other sources to determine MAGI. So tax-exempt interest can cause income to exceed the $25,000 (single) and $32,000 (married) base amounts at which benefits begin to be taxed.
Retirees required to declare Social Security benefits on the 1040 forms should check the rules of the states in which they have to file returns. Social Security benefits often escape state income taxes.
In California and New York, for example, Social Security benefits are a subtraction on page one of the return when computing taxable income.
The tax-generating thresholds of $25,000 or $32,000 are not indexed—that is, adjusted upward annually to take into account the effect of inflation—whereas the law authorizes indexing for tax brackets, dependency exemptions and the standard deduction amounts for individuals who choose not to itemize their spending for write-offs like mortgage interest. Accordingly, persistent inflation at even its present low levels assures the IRS of a growing share in the Social Security benefits eventually received by many of today’s younger workers.
This lack of upward adjustments effectively creates a golden parachute for Uncle Sam. Higher tax revenues are generated from workers who retire with fully taxed employer-sponsored pensions (a perk enjoyed by a steadily decreasing number of individuals) or traditional IRAs and supplement their Social Security and pensions with withdrawals of money that they conscientiously socked away for their old age in 401(k)s or IRAs, likewise fully taxed, as is income received from other savings and investment arrangements.
Still, taxation of Social Security benefits should not stop workers from accumulating funds in tax-deferred retirement plans. They will remain a worthwhile option, particularly because of continued concern that the need to raise revenues (government-speak for increase taxes) to offset budget deficits will compel Congress again to address the unpleasant question of how to really keep the Social Security system solvent.
This article is excerpted from “Year-Round Tax Savings,” available at www.julianblocktaxexpert.com.