The following is an excerpt from Julian Block's Tax Tips for Marriage and Divorce: Savvy Ways for Couples to Trim Their Taxes.
Americans often dream about a simplification of the Byzantine Internal Revenue Code, only to awaken and find the tax laws becoming more complicated. The rules for Social Security benefits are especially convoluted and confusing. Although most Social Security recipients escape income taxes completely on all of their benefits, middle- and upper-income level retirees have to count up to 85 percent of their benefits as reportable income.
Gift of the Magi
Taxes are triggered for Social Security recipients when their MAGI exceeds specified amounts. MAGI is an acronym for modified adjusted gross income, which, in most instances, is essentially the same amount as adjusted gross income, and not the term for the three wise men from the East who bore gifts to the infant Jesus.
To calculate whether MAGI surpasses the tax-triggering thresholds, retirees must consider income from various sources such as: salaries, pensions, dividends, capital gains, rents, Roth conversions (money moved out of traditional IRAs and into Roth accounts), and required minimum distributions (RMDs) starting at age 70 1/2 from traditional IRAs, 401(k)s, and other retirement plans.
Add to the wide-ranging MAGI tally for Social Security benefits whatever retirees receive as tax-exempt interest from municipal bonds (obligations issued by state and local governments) or from muni bond funds, as well as 50 percent of Social Security benefits.
Take, for example, a married couple that has an adjusted gross income of $31,000, tax-exempt interest of $5,000 and Social Security benefits of $28,000, for a total of $64,000. Their MAGI is $50,000 ($31,000 + $5,000 + $14,000 [50 percent of $28,000]).
The Internal Revenue Service uses a three-tiered threshold to determine the size of its bite on benefits. If MAGI is less than $25,000 for single taxpayers ($32,000 for married couples filing jointly), then benefits are not counted. If MAGI is between $25,000 and $34,000 for singles (between $32,000 and $44,000 for couples), up to 50 percent of Social Security benefits are taxed. And if MAGI tops $34,000 for singles and $44,000 for joint filers, up to 85 percent of benefits are taxed. Special rules apply to married couples who file separate returns. More on that later.
The MAGI numbers are significant for those receiving Social Security benefits because the greater the incomes they derive from sources other than Social Security, the greater the portions of their benefits that become taxable. Once beyond the top threshold, each additional $100 of income from pensions or investments can cause an additional $85 of benefits to be taxed.
Suppose Patrick and Nadine Vennebush fall into a 15 percent federal tax bracket (for couples in 2010, taxable income between $16,750 and $68,000), and they need additional funds to cover unanticipated expenses. Without considering the tax consequences beforehand, Patrick and Nadine opt to take $3,000 from a traditional IRA, a withdrawal that is in addition to any RMD. The $3,000 pushes their total income into the highest MAGI tier, thereby bumping another $2,550 (85 percent of $3,000) of benefits into taxable terrain.
That means the $3,000 withdrawal increases their income taxes by $833: the sum of $450 (15 percent of the $3,000 IRA withdrawal), plus $383 (15 percent of the $2,550 worth of Social Security benefits). Consequently, their effective tax rate on the withdrawal nearly doubles to 27.8 percent. Worse still, the federal tab is before any applicable state income taxes.
Most of the time, I encourage clients like the Vennebushes to defer taking distributions from their retirement plans for as long as possible, using only the RMD, whenever feasible, as a way of delaying the inevitable tax bite. This tactic becomes even more advantageous when there’s the potential for higher taxes on a portion of Social Security benefits.
A savvier strategy that leaves MAGI unchanged would be for the Vennebushes to take a nontaxable $3,000 from a place like a savings account and then repay the “loan.”
Alternatively, the couple could realize paper losses on investments in individual stocks, bonds or mutual fund shares to offset capital gains. They can’t offset capital losses against “qualifying dividends,” which is IRS lingo for dividends that are taxed at rates of 15 percent or zero percent; it makes no difference that those rates are the same as those for capital gains.
What if the Vennebushes have no gains to offset or losses exceed gains? They can use their losses to offset as much as $3,000 of ordinary income, such as salaries, business profits, pensions, and interest, thereby reducing MAGI. What if losses aggregate more than $3,000? Not to worry. They can carry forward unused losses indefinitely to offset future income, should that prove necessary. But the couple’s planning can come undone if they ignore or are unaware of what the IRS characterizes as the wash-sale rules.
They forfeit a current deduction for their loss if they step back into the same or “substantially identical” investment within a period that spans from 30 days before to 30 days after the sale.
Taxes on Social Security When Couples File Separately
Yet another complication is a much-misunderstood restriction for couples who opt to file separate returns. The general rule is that their threshold for exemption from taxes drops from $32,000 to zero. To qualify for relief from the general rule, the spouses must not reside together at any time during the taxable year. Stated another way, a couple who live together, even for just a day, and file separately are not allowed a base amount of $25,000 each. All of their benefits count as reportable income.
This trap snared Thomas W. McAdams, a retired Army colonel. Tom and his wife Norma stayed married but lived apart, she in the home they owned in Boise, Idaho, while for many years he lived most of the time in Ninilchik, Alaska, and other locales far from Boise. The estranged spouses listed themselves on their 1040s as “married filing separately.”
The IRS computers bounced Tom’s return. During the audit, Tom inadvertently divulged that he stayed in Norma’s dwelling for more than 30 days during the year in issue, though he always slept in a separate bedroom. That admission convinced the United States Tax Court to agree with the IRS that Tom didn’t, as the law specifies, “live apart” from his wife “at all times during the taxable year.” The 2002 decision deconstructed living apart to mean only living in separate residences, not separate areas of the same residence. It held that his visits disqualified him for the $25,000 exemption. Hence, his Social Security benefits didn’t sidestep taxes.
The 2002 decision deconstructed living apart to mean only living in separate residences, not separate areas of the same residence. It held that his visits disqualified him for the $25,000 exemption. Hence, his Social Security benefits did not sidestep taxes.
This has never been a problem for me. I do my own taxes and the 1040 Instructions have a worksheet that you just plug some of the numbers you have already entered into and it computes how much of your SS benefits are taxable income.
Don't worry about it - it's not a big deal if like most married retired couples you file a joint return.
If you get it wrong they will just send you a letter that either says that you owe them some money or you will get a refund.
Posted by: Old Limey | February 14, 2011 at 04:57 PM
Eventually 100% of your social security benefits will be taxable as their way of simplifying taxes!
Posted by: Felix Guzman | February 15, 2011 at 09:53 AM
And this, my friends, is one of the many reasons why the tax code should be completely overhauled and simplified.
Posted by: dp | February 15, 2011 at 12:02 PM
Why was it not mentioned that there are states that do not tax your SS benefits? DH gets a pension, no SS, but I believe that some states do not tax pension benefits...and that state is one state over from us, so when the time comes...
Posted by: Holly | February 18, 2011 at 09:15 AM
Oh, sorry, DUH! I forgot we were talking about Federal tax, not state. Whoops.
Posted by: Holly | February 18, 2011 at 09:16 AM