Tuesday, May 3, 2011


All too often this past tax season my explanatory memo to clients included the following phrase –

Because of the way Social Security benefits are taxed for every additional dollar you receive you are taxed on $1.85!

Whether or not your Social Security, or Railroad Retirement, benefits are taxed depends on the amount of the other income reported on your 1040 (or 1040A) – and this includes otherwise tax-exempt interest from investments in municipal bonds and muni bond funds.

To determine the taxable portion of Social Security, or Railroad Retirement, benefits you first begin with half of the gross benefits paid for the year (not the net amount actually received after deducting Medicare Part B or D premiums). You then add all the other income reported on Page 1 of your tax return – including any tax-exempt interest reported on Line 8b. If this amount exceeds $25,000, or $32,000 for married couples filing a joint return, up to 50% of your benefits will be taxed. If the excess exceeds $34,000 or $44,000 respectively up to 85% of your benefits could be taxed.

And if your income is such that part of your benefits may be taxed don’t even think about filing separately.

So you can see how an additional $1.00 of income can end up being effectively taxed as $1.50 or $1.85.

To look at this another way – a person in the 15% tax bracket would not pay $15 on an additional $100 of income, they could pay $28!

The $25,000, $34,000, $32,000 and $44,000 figures have never been indexed for inflation.

There comes a point when your level of income is such that you are being taxed on the maximum 85% of your gross benefits. In such a case additional income does not increase your taxable Social Security or Railroad Retirement – and $1.00 is taxed as $1.00.

Let us look at two situations where the inequity of this method of calculating taxable benefits is especially obvious.

(1) As I am from New Jersey, many of my senior citizen clients take advantage of the free, or almost free, buses to Atlantic City on a regular basis. I am reminded of the little old Irish man who when stopping into our storefront office years ago to pick up his finished return announced – “Just got my Social Security check. I am off to Atlantic City.” Occasionally these clients receive a Form 1099-G for winnings from the slot machines.

Case in point – one of the GDEs this year for a Social Security recipient included a Form 1099G for $1,500. The taxpayer was able to itemize and get a full tax benefit for deducting $1,500 in losses, even though her total gambling losses for the year from all sources exceeded $1,500 (losses are deductible only to the extent of winnings). The net results of her gambling activities for 2010 was “0” (actually less than 0) – so she technically did not pay any income tax on the winnings. But because of her level of income she paid tax on $1,275 more of her Social Security benefits. So her 0 dollars of net gambling winnings cost her $191 in federal income tax!

(2) We are told that the maximum tax on qualified dividends, capital gain distributions, and long-term capital gains is either 0% or 15%, depending on one’s level of income. However a net long-term capital gain of $1,500, or additional $1,500 in qualified dividends, for a Social Security recipient in the 15% tax bracket could cost the same $191 in federal income taxes – so the tax rate on the gain is about 12.75% and not 0%, or 21.25% and not 15% for someone in the 25% bracket.

How do we fix this problem?

One solution would be to tax Social Security benefits the same as any other retirement benefit with after-tax employee contributions. Use the “simplified method” to allocate a portion of each monthly benefit payment to the total employee Social Security withholdings, or for a self-employed taxpayer the Social Security share of self-employment tax, as a “return of contribution”. So a portion of each monthly payment would be tax free.

Accompanying this treatment could be a limited basic “Social Security Benefit Exclusion”, similar to the pension exclusion available on most state income tax returns, so lower income beneficiaries would continue to exclude 100% of their Social Security or Railroad Retirement benefits from federal income tax.

Under this solution additional income in other areas would not increase taxable benefits.

What do you think?


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