Look out for the Social Security tax torpedo. It may be heading toward the hull of your retirement accounts as we speak. And if it hits, you may not even realize it.
I’m in favor of taxing Social Security benefits, as the United States has done since 1983. I blogged this week against Donald Trump’s plan to stop that taxation.
But there is a problem with how it’s done. For middle-income taxpayers, different provisions of the tax code amplify one another. In certain circumstances, because of the tax torpedo and another twist nicknamed the capital gains bump zone, someone in the 12 percent tax bracket who takes a $1,000 retirement distribution could end up paying $499.50 in tax — for a marginal rate of nearly 50 percent.
There are ways to protect yourself from paying more tax than necessary, but they’re not simple. And you may not even know you could be doing better because no one tells you — least of all the Internal Revenue Service.
One of the people pointing out this problem is Wade Pfau, a retirement researcher who has a doctorate in economics from Princeton. In his “Retirement Planning Guidebook,” he calls the tax formula “loopy,” which he doesn’t mean as an insult. He means there’s literally a loop in the formulas: You don’t know your adjusted gross income until you know how much your Social Security will be taxed, “but you don’t know how much of your benefit is taxed until you know your A.G.I.,” he writes.
I talked to some other financial experts about the tax torpedo. Aaron Brask, an independent investment adviser in Lake Worth, Fla., called it “a very significant factor” for people whose annual retirement income is in the five-figure range. Brask is a former Wall Street quant with a doctorate in applied math, so he knows about complex calculations. “It’s virtually impossible for somebody to just work this out on the back of a piece of paper,” he said.