Whac-a-Mole was a truly frustrating game. Right when you smack your hammer on that mole’s head, another one pops up. It was so frustrating its name has now taken on the linguistic heights of Kleenex. Everyone knows exactly what you mean when you say it and they know how you’re feeling!
Navigating the world of Social Security is kind of like playing Whac-a-Mole. Just when you think you’ve got all the facts down, there’s yet another thing to clobber. Understanding how Social Security is taxed is particularly hairy.
Before jumping into an example, let me first state that about 45% of all retirees start to collect Social Security at the very earliest possible age of 62. Despite the massive financial incentive to file later, almost half of all retirees choose to take the money and run. What people might not fully appreciate is that for every $1.00 you’d receive at age 62, you could get about $1.75 if you waited to collect at age 70. For many reasons, good and bad, less than 5% of all retirees wait until age 70. If possible, more should delay.
To help shore up Social Security’s finances, benefits became subject to tax back in 1984. For lower income people, Social Security benefits are not included in their taxable income. For many others, a maximum of 85% of their benefit is taxed. About half of all retirees are paying some tax on their benefits. The true tax rate they pay can be surprisingly high.
For example, let’s imagine a married couple with $25,000 in pension income, $15,000 in interest income and $30,000 in Social Security benefits. Under a somewhat complex formula, this couple would see that about 50% of their Social Security is included in their taxable income. If they were to take $12,000 out of their IRA to help pay for a new car, the maximum 85% of their Social Security benefit would then be counted as taxable income.
Just like that frustrating game of Whac-a-Mole, the $12,000 IRA distribution for their new car resulted in about $10,000 more of their Social Security popping up on their tax return. It is very understandable for this couple to believe they’d pay tax in the 12% federal tax bracket on their IRA distribution. For them and the majority of other Social Security beneficiaries, however, the 12% tax bracket is a mirage. Without some tax planning, this couple really pays tax at a much higher marginal rate of 22.2%. I’ll say it again, Whac-a-Mole is really no fun!
To learn a bit more about the world of Social Security, attend the next Money Series on Wednesday, February 12 at 6:30pm in the McGuire Room at Traverse Area District Library. The Money Series is a Traverse City-based nonprofit committed to providing open access to financial education, for all. Register at MoneySeries.org or call (231) 668-6894.