The US Tax Code is full of inequities and basic “unfairness”. One example of this “unfairness” is the method for taxing Social Security and Social Security equivalent Railroad Retirement benefits.
When I first started out in the business Social Security was not taxed. It first became taxable under Reagan in 1984. Originally only up to 50% of benefits were taxed – the thinking being half of the contributions to Social Security are made by employees and half by employers, so only the employer half would be taxed. This maximum was later raised to 85% so the “earnings” on Social Security benefits would also be taxed.
Because of the way Social Security and equivalent Railroad Retirement benefits are currently taxed it is very possible that for every additional $1.00 of income you pay tax on $1.85. So, income that falls within the new 22% bracket can be effectively taxed at 40.7% - almost 4% above the current top tax rate.
Social Security and Railroad Retirement benefits are taxed based on the extent of your other taxable income and tax-exempt interest. You could pay tax on up to 50% or 85% of the gross benefits. So, an additional $100 of dividends, or interest or capital gains or W-2 income can cause an additional $85 of your benefits to be taxed, so the $100 increase causes your AGI to increase by $185.
Because taxable Social Security and Railroad Retirement benefits increase AGI, increases could also reduce tax deductions and credits that are affected by AGI – increasing the effective tax rate of the increase. The increased AGI can, for example, result in some qualified dividends and long-term capital gains being effectively taxed at more than the “advertised” 0% or 15% rate.
The Solution – tax Social Security benefits the same as any other pension with “after-tax” employee contributions, using the “Simplified Method”. The taxable portion of the benefit would be calculated by SSA and reported as such on the SSA-1099 and RRB-1099, similar to the way partially taxable pension income is reported on the Form 1099-R.
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