Watch For The Income Tax Torpedo
The possibly lurking Social Security tax torpedo is a situation where an extra dollar of income not only gets taxed at your highest marginal tax rate, it also may cause previously untaxed Social Security benefits to be taxed.
So instead of adding $1 to taxable income, you must add $1.50 or $1.85 to taxable income, the extra 50 or 85 cents being the Social Security that is now taxable because the extra dollar of income has pushed your provisional income over one of the taxation thresholds. This essentially causes your extra income to be taxed at 150% or 185% of your usual tax rate.
We don’t hear much about the tax torpedo much anymore. In part because the Social Security income thresholds—which were set in 1984 and 1993 by Congress are never adjusted for inflation. They are so low now that many already pay income taxes on 85% of their Social Security benefits.
It’s pretty hard today to live on these amounts unless your mortgage is paid off and you’re living a frugal lifestyle (or else you are enjoying tax-free life insurance or Roth distributions as a result of smart pre-planning).
Even if you can live on these low amounts, it may be impossible to avoid receipt of income that will push you over the threshold. As Social Security benefits grow while the taxation thresholds remain fixed, more people will be subject to taxation on their benefits simply due to the benefits themselves, and the tax torpedo may no longer be relevant.
For those who have not maxed out their Social Security and who are managing to live under the thresholds, once IRA required minimum distributions (RMDs) start at age 70½, there’s no disclaiming that income, unless you give it all away directly to charity or you have converted to a Roth or taking advantage of tax-free life insurance distributions.
The only available sources of tax-free income that remain are from your Roth and properly designed life insurance distributions.
Another reason the tax torpedo has lost some of its headline-grabbing energy is that tax rates are lower for now. But, the Trump tax cuts will only last until 2025 and rates will probably be headed back up (if not sooner).
We always watch for the tax torpedo and avoid it when possible (sometimes it’s too late). You must be aware of the tax torpedo and put in place strategies now to avoid it.
