The Stealth Tax On Your Social Security

Social security benefits first became taxable in 1983.

The law was relatively straightforward:

·        Half of one’s social security became taxable as adjusted gross income exceeded

o   $32,000 for marrieds filing jointly,

o   $25,000 for everyone else, except for

o   Marrieds filing separately, whose threshold was zero (-0-)

Clearly the tax law frowned on married social security recipients filing separately.

The Senate Finance Committee Report commented on why any social security was being taxed at all:

… by taxing social security benefits and appropriating these revenues to the appropriate trust funds, the financial solvency of the social security trust funds will be strengthened.”

Uh, sure.

In 1993 Congress laid a second grid on top of the 1983 law:

·        85% of one’s social security as adjusted gross income exceeded

o   $44,000 for marrieds filing jointly

o   $34,000 for everyone else, except for

o   Marrieds filing separately, whose threshold remained at zero (-0-)

Depending on where one is income-wise, part of one’s social security can be taxed at 50% and another part at 85%. Make enough and a clawback kicks-in: all your social security will be taxable at 85%.

Seems a bit complicated for a tax provision that snags ordinary people.

So in 1983, if you were married, filing joint and your income was less than $32 grand, your social security was not taxed.

I was curious: what is the equivalent of $32,000 of 1983 dollars in 2019?

Approximately $82 grand.

Wow!

I was also curious: how have the income thresholds for social security changed over three-plus decades?

Here are the thresholds for 2018:

·        $32,000/$25,000

·        $44,000/$34,000

They have not changed at all.

Meanwhile you need almost three 2019 dollars to equal one dollar from 1983.

So let me get this right.

IRA deductions are indexed for inflation. Gift taxes are indexed for inflation. The income thresholds for the new 20% passthrough deduction are indexed for inflation.

But the tax on social security is not.

What a nice gimmick. Even if you started out below the tax threshold, inflation over time would probably put you above the tax threshold.

The cynicism from our politicians is stunning.

Tax Return That Surprised An Accountant

Let’s do something a little different this time.

I want you to see numbers the way a tax CPA does.

Let’s say that you are semi-retired and you bring me your following tax information:

                    W-2                                         24,000

                    Interest income                            600

                    Qualified dividend income      40,000

                    Long-term capital gains          10,000

                    IRA                                         24,000

Looks to me like you have income of $98,600.

How about deductions?

                    Real estate taxes                    10,000

                    Mortgage interest                      5,000

                    Donations                                26,000

I am seeing $41,000, not including your exemptions.

You did some quick calculations and figure that your federal taxes will be about $6,500. You want to do some tax planning anyway, so you set up an appointment. What can you do to reduce your tax? 

What do I see here?

I’ll give you a hint.

Long-term capital gains have a neat tax trick: the capital gains tax rate is 0% as long as your ordinary income tax rate is 15% or lower. This does not mean that you cannot have a tax, mind you. To the extent that you have taxable income in excess of those capital gains, you will have tax.

Let’s walk though this word salad.

Income $98,600 – deductions $41,000 – exemptions $8,100 = $49,500 taxable income.

You have capital gains of $10,000.

Question: will you have to pay tax on the difference – the $39,500?

Answer: qualified dividends also have a neat tax trick: for this purpose, they are taxed similarly to long-term capital gains.

NOTE: Think of qualified dividends as dividends from a U.S. company or a foreign company that trades on an U.S. exchange and you are on the right path.

You have capital gains and qualified dividends totaling $50,000.

Your taxable income is $49,500.

All of your taxable income is qualified dividends and capital gains, and you never left the 15% tax bracket.

What is your tax?

Zero.

How is that for tax planning, huh?

From a tax perspective, you hit a home run.

Let me change two of the numbers so we can better understand this qualified dividend/capital gain/taxable income/15% tax bracket thing.

                    W-2                                         36,000

                    Qualified dividends                 28,000

As you probably can guess, I left your taxable income untouched at $49,500, but I changed its composition.

You now have capital gains and qualified dividends of $38,000. Your taxable income is $49,500, meaning that you have “other” income in there. You are going to have to pay tax on that “other” income, as it does not have that qualified dividend/capital gain trick.

The tax will be $1,153.

You still did great. It is just that no tax beats some tax any day of the week.

It is something to consider when you think about retirement planning. We are used to thinking about 401(k)s, deductible IRAs, Roth IRAs, social security and so on, but let’s not leave out qualified dividends and capital gains. Granted, capital gains are unpredictable and not a good fit for reliable income, but dividend-paying stocks might work for you. When was the last time Proctor & Gamble missed a dividend payment, for example?

OK, I admit: if you leave the 15% tax bracket the above technique fizzles. That however would take approximately $76,000 taxable income for marrieds filing jointly. Congrats if that is you.

BTW I saw scenario one during tax season (I tweaked the numbers somewhat for discussion, of course). The accountant was perplexed and asked me to look at the return with him. The zero tax threw him.

Now he knows the dividend/capital gain thing, and so do you.