In 1983, Congress passed a rule that made Social Security distributions taxable for the first time since it began. Up to 50% of Social Security could become taxable under a quirky formula if “combined income exceeds a threshold amount” which, at the time, was $25,000 for an individual and $32,000 for a married couple. These threshold amounts were never set to include an adjustment for cost of living increases.
10 years later in 1993, Congress decided to add a second tier so that up to 85% of Social Security could become taxable if combined income was above $34,000 for an individual and $44,000 for a married couple. These thresholds were again never set to include an adjustment for cost of living increases.
Fast forward to present day and we still have those same thresholds from 1983 and 1993, yet a much higher cost of living. This is effectively creating a hidden tax increase as inflation rises over time. More than 20 million retirees are now paying taxes on their Social Security benefits.
There is a silver lining to this story. You see, Social Security isn’t taxable by itself. The combined income formula needs taxable income from things like IRA distributions or Pensions to go into effect. The Tax Relief Act of 1997 created a new version of IRA called the Roth. This was a game changer. It allowed Americans to put money into an account after taxes were paid and not be subject to taxes when distributed later on in retirement. Because Roth distributions fall outside of the combined income calculation, they do not cause a tax on Social Security.
And it gets even better. In 2010, earnings caps were removed for Roth Conversions allowing anyone to convert from a Traditional to Roth IRA. This created a game of sorts where those who understand the rules can potentially take advantage of them and reduce or eliminate Social Security taxes altogether. We call this game Tax Diversification.
In the next post, I will discuss how life events leading up to and through retirement open up tax diversification opportunities that can affect how your clients are taxed in retirement.
Stay tuned for more blog posts and other great Tax Savvy Content.