Social Security can indeed be taxed, despite the feeling that you’re getting taxed twice.
This year, 89% of all federal tax revenue is only going to go towards four things: Social Security, Medicare, Medicaid, and interest on the debt. These are non-discretionary spending items. It would take an act of Congress to choose not to pay for them and doing so would result in a worldwide depression.
That means that only 11% is left to fund everything else in the budget and that doesn’t include the additional trillion dollars we spend above and beyond the federal tax revenue.
We are going to come to a point where we have a sovereign debt crisis and will have to either dramatically reduce spending, increase tax revenue, or some combination of both.
Provisional income is the income that the IRS keeps track of to determine if your Social Security will be taxed. Any 1099’s coming out of your taxable bucket, including investments that generate income or dividends, count as provisional income. The same is true for any distributions from qualified plans and 401(k)’s in your tax deferred bucket.
Most people have no basis in their 401(k). They used pre-tax dollars to fund those accounts and when they take that money out the IRS is going to count 100% of it as provisional income. Any sort of taxable income that accrues to you during retirement will count as provisional income.
The kicker is one half of your Social Security counts as provisional income. If, as a single person your provisional income adds up to $25,000, or as a married couple it adds up to more than $32.000, up to 50% of your Social Security can become taxable to you at your highest marginal tax bracket.
It’s important to remember that your standard deduction has nothing to do with your provisional income.
Interest from your municipal bonds counts as provisional income, which is the reason we aren’t very keen on them since they don’t count as true tax-free investments.
There is a longform process you can use to determine your provisional income, but there is also a short cut.
Many people think that provisional income is based on a threshold and if they exceed that number, they are taxed at their highest marginal tax bracket, but that’s not how it works. It’s graduated, so you have to get well above the threshold to feel the full brunt of the tax.
Somewhere between $80,000 and $85,000 in provisional income is where your Social Security will be taxed at your highest marginal tax bracket.
Many financial advisors think about provisional income incorrectly. We have to recognize that provisional income works in a graduated system and there are ways to keep your provisional income low enough to make your Social Security tax-free.
You have to remember that even before you take the first dollar out of your IRA, you are already at the 50% mark, so you have to keep the balance of your IRA low enough that the RMD coming out of it will keep you below the threshold. For most people, the magic number is around $350,000.
Why is it such a big deal to keep your Social Security tax-free? The way that most Americans pay taxes on their Social Security is by taking more money out of their IRA’s and 401(k)’s, but what happens if tax rates double?
When your Social Security gets taxed, you run out of money 5 to 7 years faster than someone that isn’t having the Social Security taxed. The act of compensating for Social Security taxation forces you to spend down your other assets that much faster.
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