Beat Taxes On Social Security Benefits

The 90% marginal tax bracket is alive and well. Most people believe that such high marginal tax rates ended with the 1981 and 1986 tax cuts. For most taxpayers, they did. But those high marginal tax rates exist today and are reserved for retirees.

Many of you who recently completed your federal income tax returns know what I mean. The marginal tax rate is the effective rate you pay on the last dollar of income earned. A marginal tax rate of 70% or more applies to many Americans who receive Social Security benefits.

Social Security benefits originally were tax free. In the 1980s, taxpayers with adjusted gross incomes above $32,000 began to have up to 50% of their benefits taxed. In the 1993 tax law, those with income exceeding $44,000 began to have up to 85% of their benefits taxed. The details of computing the tax are complicated, and can be found in IRS Publication 915 (call 800-TAX-FORM) or in my Retirement Tax Guide (800-552-1152).

Suppose Max Profits has adjusted gross income of $31,999. He gets a distribution from a mutual fund that pushes AGI to $32,100. The distribution is taxable. In addition, it causes Social Security benefits that were tax free to be taxed. Each additional dollar of income earned means more than one dollar is included in income. Plus, including the benefits in income could cause Max’s personal exemptions and itemized deductions to be reduced. In most states there also are state income taxes.

That’s why if you are in a high tax state, such as California, and have an AGI above $44,000, your marginal tax rate on each additional dollar earned could reach 90%. With Social Security benefits indexed for inflation and the threshold for taxation held steady, the number of seniors subject to this tax increases each year.

Fortunately, there are steps you can take to reduce the taxes on your Social Security benefits.

First, let’s throw out a couple of strategies that won’t work. Delaying benefits so that only the lower-earning spouse receives them doesn’t work. The combined joint income of the two spouses is used to determine the tax. Married filing separately also won’t help. In fact, it will make the tax worse, because the benefits will be taxed when adjusted gross income is above $0.

Now, let’s look at what might work for you.

Tax deferral is an easy way to reduce the taxes on your benefits. If you are earning taxable income that you don’t need, it could be beneficial to defer that income. There are a number of possible strategies.

• Don’t take distribution from IRAs, pension accounts, or annuities until you need the money to pay expenses. Once you pass age 70 1/2, the required minimum distributions rules for qualified retirement plans, including IRAs, make this harder with qualified retirement plans. But before that age you can manage it.

• Taxable accounts can be re-invested to reduce taxable income. Mutual funds can be replaced with index funds or others that generally have low annual distributions. You might owe capital gains taxes when selling the old funds to buy new ones, but the move could save taxes down the road.

• Taxable accounts also can be used to purchase fixed or variable annuities. Income and gains in the annuities will be tax deferred until you actually take distributions. Annuities are not subject to the required minimum distribution rules, so money can be left in the annuities until you really need it.There are additional costs associated with annuities, and you lose some flexibility. I generally recommend that variable annuities be used only when you can let the money alone for at least 10 years for a low-cost annuity and 15 years for an average-cost annuity.

• Variable life insurance also can defer taxes on investment income. You can choose how the cash value account is invested from among funds offered by the insurer. Part of your money will be used to purchase life insurance coverage. If your heirs eventually benefit from the insurance, the policy allows you to leave them several times more money than if they simply inherited your taxable accounts. An added benefit is that when you need cash, tax-free loans can be taken from the cash value account. There are, of course, additional expenses with these policies. Full details of variable life insurance are in my January 2000 issue and in the archives section of the web site.

Shifting income to other family members is a good way to reduce income taxes and also a good estate planning strategy. When your assets exceed what you anticipate needing for the rest of your life, it can be a good idea to give assets to other family members either directly or through trusts. That gets the property out of your estate and also gets the income off your tax return.

Tax-exempt interest can reduce your taxes on Social Security benefits. You cannot avoid the taxes on benefits by having all your income be tax-exempt interest. The computation of taxes on the benefits requires you to count the tax-exempt income. But tax-exempt bonds generally pay less interest than comparable taxable bonds to compensate for their tax-free status. That means after adding in the interest, your income will be less when you use tax-exempt bonds. If you earn a lot of income from interest, give careful consideration to using tax-exempt bonds.

Several deductions can reduce the taxes on Social Security benefits. Look for opportunities to boost the amount of those deductions. Itemized deductions (mortgage interest, medical expenses, real estate taxes, and state income taxes) do not reduce the tax on benefits.

But deductions for capital losses reduce the tax on benefits. You can shelter your capital gains dollar for dollar with capital losses. When losses exceed your gains for the year, up to $3,000 of capital losses can be deducted against other income. Additional losses can be carried forward to future years.

Each year, look for opportunities to sell investments with paper losses to offset capital gains for the year. Even if you don’t sell any investments for a gain during the year, assume that some mutual funds will make taxable distributions. Also, realize that the ability to carryforward capital losses lets you accumulate a bank of losses to be used against future gains and income by selling whenever a market downturn gives you some paper losses.

You still can sell an asset if you like its long term prospects. To take the loss, you have to wait at least 31 days to repurchase the asset. You can sell a fund, wait 31 days, and repurchase the fund. Or you can purchase a different fund with a similar investment style immediately and not be out of the market. Be sure to check sales charges and redemption fees before making the tax sales.

Business loss deductions also can reduce taxes on Social Security benefits. The amount of deductible losses is not limited. You might find it beneficial to turn a hobby into a business that generates a tax loss. The losses can be deductible if you make a profit in at least three out of any five consecutive years. Or you can never earn a profit and still deduct the losses if you are running the activity in a professional manner with the intention of making a profit. More details are in the report, The New Rules Of Retirement, that is sent to new subscribers.