Summary/TLDR
The “Social Security tax-torpedo” refers to the tendency of more social security benefits to be “pulled in” to one’s taxable income due to the unique nature by which social security is taxed, effectively increasing one’s marginal tax rate within certain ranges of income. Common strategies used to avoid or mitigate the effect of this tax-trap include delaying social security benefits, Roth conversions, and the implementation of an integrated distribution strategy into one’s retirement plan. The difference between good planning and bad planning as it pertains to social security can be hundreds-of-thousands of dollars in lifetime tax savings.
Introduction
Many are at least vaguely familiar with the nuanced rules regarding the timing of their election of Social Security benefits, but very few understand the additional complexity of exactly how their benefit will be taxed. And since Social Security will be a substantial source of income for most retirees, a rudimentary understanding of social security taxation is in order. Specifically, an understanding of a common tax-trap known as the “social security tax-torpedo”, and how to avoid it, will go a long way towards improving one’s tax planning.
Provisional Income and Understanding the Taxation of Social Security
First, we must discuss how social security taxation is determined. In the introduction, notice that I stated that up to 85% of your social security benefit could be considered taxable. The variable that determines where you fall on the 0-85% of taxable benefits is known as your provisional income. For our purposes, we will define provisional income as your taxable income (not including your social security benefit) plus half of your social security benefit. It is technically more nuanced than this, but this is close enough for the purposes of this piece.
Once your provisional income is calculated, it is put through a series of formulas to determine how much of your social security benefit will be taxable.
Clearly, then, being able to manipulate your provisional income and keep it low can have dramatic impacts on your tax picture from year-to-year. For example, if you and your spouse have $40,000 in annual social security benefits, 85% of which ($34,000) is taxable, that would add $4,080 to your tax bill assuming a marginal tax rate of 12%.
However, if you were able to reduce your provisional income to the point where, say, only 35% of your benefit was taxable ($14,000), then taxes on this same benefit of $40,000 would only be $1,680. While this $2,400 tax savings might not be a life-changer if realized for a single year, it can make a huge difference when realized over the course of a 30+ year retirement.
The Social Security Tax Torpedo
You might have noticed from the explanation above that having a high taxable income will hit you in two ways – each additional dollar of taxable income will also increase the amount of your social security benefit subject to taxation. In other words, every additional dollar of taxable income is pulling in more of your social security benefit to be taxable as well. This “pulling in” of more social security to be considered taxable is known as the “Social Security Tax Torpedo”.
Let me demonstrate with a quick example. Let’s assume Mary and Joseph have the following sources of income: $54,000 in social security benefits, $25,000 in pension income, and $15,000 in IRA distributions. After taking the standard deduction, their taxable income would be about $34,850. But what if their IRA distributions were $25,000 instead of $15,000? You might think that this would just increase their taxable income by $10,000 to $44,850, but it increases it to $53,350! This is because the additional taxable income also increased Mary and Joseph’s provisional income, which “pulled in” an additional $8,500 of social security benefits into their taxable income as well.
Avoiding the Social Security Tax Torpedo
1. Delaying benefits
Social security is unique in that only 85% of it could ever be taxable. This means that by delaying social security, you not only increase your benefit, but you also increase the amount of tax-free income you will receive as well.
Consequently, delaying social security will also keep your provisional income relatively lower since only half of it is included in provisional income. As can be concluded from our discussion above, this keeps the dreaded “tax torpedo” at a further distance.
2. Roth conversions
While Roth conversions will increase your tax liability in the year you make them, they can help create opportunities to decrease taxes for many years into the future. In short, the tax savings realized from Roth conversions are not isolated to the conversion itself, but can become part of an integrated distribution strategy (discussed below) to realize huge potential savings.
3. Engaging in an “integrated” distribution strategy
Finally, the implantation of a distribution strategy centered around tax-efficiency is paramount in avoiding the torpedo and keeping taxes low. Knowing exactly how much you can take from one type of retirement account before running into tax-inefficiency can literally save you thousands in taxes annually. Consider the following examples:
In 2023, if you and your spouse drew $50,000 in distributions from your Traditional IRA and received a combined social security benefit of $34,000, then federal income taxes for the year would be $4,940 with 75% of your social security being taxable. If you instead took only $35,500 from your Traditional IRAs and $11,360 from Roth IRAs, your tax bill would shrink to $1,800 because only 39% of your social security would be taxable.
Adding in the additional strategy of delaying social security benefits as mentioned above only further improves their picture. Continuing our example, if benefits were delayed until age 70, you would only need $27,500 from your Traditional IRA and $10,070 from your Roth to receive the same net income, but your tax bill for the year would only be $670!
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