Last week, a retired reader wrote about discovering he was in a higher tax bracket than he expected to be.
He isn’t alone. An entire generation of middle-income savers has been hoodwinked by federal tax policy in a true “give with one hand, take with the other” gesture. If you are retired and reading this, there’s a big chance you are one of them. Here’s how it happened.
Congress voted, in 1983, to start taxing Social Security benefits. The formula for taxation was written in such a way that few retirees would be affected in 1984. But the provision wasn’t indexed for inflation. So more retirees pay the tax every year.
They aren’t fat cats. As I demonstrated last week, the taxation of Social Security benefits is strictly a middle- class tax. It can nearly double a tax bill for total incomes well under $100,000.
During the same period, workers were encouraged to participate in defined contribution retirement plans and Individual Retirement Accounts. The idea was that you could reduce your tax bill while working, enjoy tax-deferred growth and pay taxes at a much lower rate when retired.
But taxes are complicated. And the slow escalation of the tax on Social Security benefits was neither mentioned nor considered.
To have useful information, we have to watch what economists call our marginal tax rate. That’s the tax rate we pay on our highest dollar of income. If you can earn an additional $1,000 and it is taxed at 10 percent, you’ll be a lot more eager than if you earn an additional $1,000 and it is taxed at 40 percent. And if your next $1,000 of income is taxed at 100 percent, well, you might not show up for work at all. That, of course, assumes you have a choice.
So, let’s see what the marginal tax rate is for the retired couple with average Social Security benefits that I examined last week. If we add the average Social Security worker’s retiree benefit and the related spousal benefit, we know that a typical retirement starts with a Social Security income of $23,343. (Yes, benefits can be higher, or lower. But when the Social Security Administration cuts the checks, this is a typical amount for a couple.)
If you have no other income, that $23,343 will be tax-free. In fact, you can have other income of $18,000 and still have no income tax to pay.
The trouble starts with more income. Here are the figures:
An additional $6,000 (total other income $24,000) creates a federal income tax bill of $343. This implies a marginal tax rate of 5.7 percent ($343/$6,000). That isn’t much to complain about.
Another $6,000 (total other income $30,000) increases the tax bill from $343 to $1,265, an increase of $922. This implies a marginal tax rate of 15.4 percent. Again, not much to complain about.
But add $6,000 more (total other income $36,000) and the tax bill rises to $2,561, an increase of $1,296. That’s a marginal tax rate of 21.6 percent on the added $6,000. The total income involved is $59,343, and our tax law says that taxable income on a joint return up to $72,501 is taxed at no more than 15 percent.
But wait, it gets worse.
Add another $6,000, bringing the total income from all sources to $65,343, and the tax bill increases from $2,561 to $4,256, an increase of $1,695. That’s a marginal tax on the last $6,000 of 28.2 percent.
Let’s try to get our heads around this. This retired couple has a total income of $65,343, yet they pay taxes at a 28.2 percent rate on the last $6,000. Meanwhile, a non-retired couple needs a taxable income more than $146,400 to pay taxes at a 28 percent rate. Does that strike you as reasonable tax policy?
Me neither. It strikes me as a punitive tax for middle-class savers who are retired.
But what about another possibility? Could the revenue from the tax help Social Security remain solvent? Answer: No way.
According to the most recent Trustees Report, the tax now provides only 3.2 percent of total revenue. It will rise to only 4.8 percent by 2022. So the tax is a small benefit for Social Security, but a big burden for retirees.
SCOTT BURNS is a principal of Plano-based investment firm AssetBuilder Inc. His e-mail address is email@example.com.
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