Monday, April 28, 2014
HOW THE US TAX CODE SCREWED SOME OF MY CLIENTS WHO RECEIVE SOCIAL SECURITY OR RAILROAD RETIREMENT BENEFITS THIS TAX SEASON
This past tax filing season I had to explain to one taxpayer in the 15% federal tax bracket why $8,000 in additional qualified dividends and long-term capital gains, which the IRS tells us is taxed at the rate of 0%, cost $1,097 in federal income tax (13.7%).
And to another, in the 25% bracket, why $10,000 in additional rental income cost $4,625 in federal income tax (46.25%).
The reason lies in the way Social Security and Railroad Retirement benefits are taxed.
This could also cause a taxpayer in the 15% bracket to pay $638 in federal income tax on $5,000 in tax-exempt municipal bond interest (12.75%).
If you are collecting Social Security or Railroad Retirement for every $1.00 of additional taxable income you could be paying tax on $1.50 to $1.85. And for every $1.00 of tax-exempt municipal bond income you could be paying tax on 50 to 85 cents.
The amount of Social Security or Railroad Retirement benefits that are taxed by Uncle Sam depends on the amount of your other taxable and tax-exempt income. The maximum amount of benefits that are taxed is 85%. If your gross Social Security benefits, before deducting Medicare Part B and Part D premiums, is $18,000 the most you will be taxed on is $15.300.
If, based on your other income, the maximum 85% of your benefits are already being taxed then every additional $1.00 in taxable income is taxed as $1.00, and every additional $1.00 in tax-exempt municipal income is totally tax free (unless you are a victim of the dreaded Alternative Minimum Tax and you have income from private activity bonds).
It is important for Social Security and Railroad Retirement beneficiaries to know where they stand regarding the taxability of their benefits so that they can understand how much additional taxable and tax-exempt income will cost in terms of federal income tax.
And so that their tax preparer does not put them in shock at tax time if they did well in the market or had additional income from another source during the year.
So here is how Social Security and Railroad Retirement benefits are taxed –
Start with one-half (50%) of your gross Social Security or Railroad benefits (from Box 5 of Form SSA-1099 or RRB-1099) – combined if filing a joint return.
To this number you add all other taxable income (Form 1040 Lines 7, 8a, 9a, 10-14, 15b, 16b, 17-19, 21).
Next you add the amount of tax-exempt interest reported on Box 8b of Form 1040. While municipal bond interest is exempt from federal income taxation, it is included in the calculation of taxable SS or RR benefits – so in reality up to 85% of tax-exempt municipal interest could be subject to federal income tax.
From the total of these three amounts you subtract the total “adjustments to income” from Form 1040 line 23 – 32 plus any write-in adjustments included in Line 36. Deductions for student loan interest, tuition and fees, and domestic production activities, the adjustments reported on Form 1040 lines 33, 34, and 35, are not allowed in calculating taxable benefits.
If this amount (50% of benefits + other taxable income + tax-exempt interest – most adjustments to income) is more than $25,000 (but not more than $34,000) if you file as Single, Head of Household, or Qualifying Widow(er) or $32,000 (but not more than $44,000) if you are Married Filing Joint than you will pay federal income tax on up to 50% of your total gross benefits.
If the amount is more than $34,000 if Single, Head of Household, or Qualifying Widow(er) or $44,000 is Married Filing Joint you will pay federal income tax on up to 85% of your total gross benefits.
If you are filing as Married Filing Separately and you lived with your spouse at any time during the year you will pay tax on 85% of your Social Security or Railroad Retirement benefits. If you file separately and you and your spouse lived apart for the entire year you calculate the taxable benefit as if you are a Single individual.
Click here to download the IRS Social Security Benefits Worksheet.
Here is another example of how this method of taxing benefits screws taxpayers. Let’s say you itemized in 2013 and claimed a deduction for the full amount of state income taxes withheld or paid in via estimated tax during the year. When you prepared your state return you find you are getting a $300 refund. When you prepare your 2014 Form 1040 you will report this $300 refund as taxable income Line 10. If you are receiving Social Security this could cost an additional $255 of your benefits to be taxed.
If you are in the 15% bracket for both 2013 and 2014 this $300 provided a tax benefit of $45 on your 2013 return, but will cost you $83 in federal income taxes in 2014. The solution is to claim the exact amount of your state tax liability as a deduction on Schedule A instead of the total amount paid, or to claim a deduction for state and local sales tax.
If we are going to tax Social Security and Railroad Retirement benefits how should they be taxed? I have suggested we tax these 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.