Personal Finance

How Worried Should I Be About the ‘Tax Torpedo’?

July 10, 2019
Roger Young, CFP®, Senior Financial Planner
It’s important to prepare for taxes in retirement, which can be complicated due to Social Security and other income sources with different tax characteristics.

Key Points

  • People in the 10%, 12%, and 22% federal tax brackets could be affected by the “tax torpedo”—a high marginal tax rate caused by taxation of Social Security benefits.
  • Planning ahead of required minimum distributions (RMDs) can help minimize or avoid the torpedo’s negative effects.
  • The tax torpedo tends to affect people with relatively large Social Security benefits. But that’s not a good reason to claim Social Security early.

For most people, federal income taxes are straightforward during their working years because income is primarily from a paycheck. However, in retirement it can become much more complicated because your income may come from multiple sources with different tax characteristics.

A key component of your income in retirement is Social Security. A calculation based on your overall income dictates how much of your Social Security benefit is taxable. That calculated income (sometimes called “provisional” or “combined” income) is essentially half of your Social Security benefit plus your other gross income and any tax-exempt interest.

None of your Social Security benefits are taxable up to a certain threshold of provisional income. For income above that threshold, there’s a graded scale of taxation:

  • If your provisional income is $25,000 to $34,000 (or $32,000 to $44,000 for joint filers), then up to 50% of your benefits are taxable.
  • If your provisional income is more than $34,000 ($44,000 for joint filers), then up to 85% of your benefits are taxable.

This can create a unique situation to avoid: what researchers dub the “tax torpedo.” You’ve been hit by this torpedo if you pay a high marginal tax rate because additional income causes more Social Security to become taxable. The marginal rate then decreases at higher income levels, which may not be something you’d expect in our progressive tax system.

Here’s an example of how you could be hit by this tax torpedo.

Suppose you and your spouse collect $60,000 in combined annual Social Security benefits. Your only other income so far this year is $65,000 of distributions from IRAs. Your provisional income is $95,000. At that level, you haven’t quite reached the 85% cap on taxability of Social Security. If you take an additional $1,000 from your IRA, you might expect to pay $220 more in taxes since you’re in the 22% bracket. However, since that $1,000 results in $850 more Social Security subject to tax, your tax bill actually goes up by $407 ($1,850 times 22%). Your marginal tax rate is really 40.7% at this point, but at higher income levels it eventually goes back down to 22%.

So how bad is this torpedo, and what should you do about it?

1.       Figure out whether you’re a likely target.

The first step is being aware that this may be an issue. It may not be obvious, even looking at your tax return or software. One common trigger is required minimum distributions (RMDs), since you have no choice but to receive taxable income.

People in the 10%, 12%, and 22% federal tax brackets could be affected, especially if they paid the maximum Social Security payroll tax in some of their working years. If you expect to be in one of these brackets, consider working with a financial planner or tax professional to fine-tune your retirement expense, income, and tax projections. That can help you determine whether additional planning is necessary.

Your Marginal Tax Rate
Ordinary Marginal Tax Rate (A)   Additional Social Security Benefits Taxed (B)  

Total Marginal Rate

(A x (1+B))

10%
50% 15%
10% 85% 18.5%
12% 50% 18%
12% 85% 22.2%
22% 85% 40.7%

Note: Not all people in these brackets will have the higher marginal rate.

While “torpedo” sounds bad, a 22.2% marginal rate isn’t exactly disastrous. With that in mind, you might focus on situations resulting in the 40.7% marginal rate.

A Torpedo Worth Avoiding:
Approximate Income Ranges Resulting in 40.7% Marginal Tax Rate

 

Married Filing Jointly

Social Security Income 
Other Ordinary Income    Total Gross Income   
$55,000 $62,000- $64,000 $117,000- $119,000
$60,000 $60,000- $67,000 $120,000- $127,000
$70,000 $58,000- $72,000 $128,000- $142,000
$80,000 $56,000- $77,000 $136,000- $157,000
$90,000 $54,000- $82,000 $144,000- $172,000

 

Single
Social Security Income Other Ordinary Income Total Gross Income
$20,000 $37,000- $39,000 $57,000- $59,000
$25,000 $36,000- $41,000 $61,000- $66,000
$30,000 $35,000- $44,000 $65,000- $74,000
$35,000 $34,000- $46,000 $69,000- $81,000
$40,000 $33,000- $49,000 $73,000- $89,000
$45,000 $32,000- $51,000 $77,000- $96,000

Assumptions: All filers are over age 65 and use the standard deduction.  While qualified dividends and long-term capital gains are included in the definition of provisional income, they are not considered in this illustration.

2.      Start planning well before you reach age 70½.

The tax torpedo is just one reason to plan thoroughly years ahead of RMDs. If you don’t think you’ll need all of your RMDs for spending in retirement, you might consider a series of Roth conversions before turning 70. While you will have to pay taxes on the conversions, you reduce RMDs later.

For example, suppose that the same couple with $60,000 of Social Security benefits had non-retirement assets to fund their spending and taxes before age 70.  They could have potentially converted Traditional IRA assets to a Roth IRA at a 12% tax rate. That would reduce RMD income later in the 22% bracket, including some effectively at the 40.7% “torpedo” rate. That could save them tens of thousands of dollars in taxes in retirement.

 

3.       Consider course corrections.

Either before or after RMDs, having some flexibility can help you limit highly-taxed income. If you’re approaching a torpedo range, you may want to fund additional spending needs with income sources that generate little or no taxable income. This could include drawing on your cash reserve, a Roth account, or the sale of investments with small gains. If you’re at the high end of the torpedo range, you could take more taxable distributions once you’re past the 85% cap, freeing up cash to use next year so you can stay below the range.

 

4.       Don’t let taxes trick you into a bad Social Security claiming decision.

The torpedo tends to hit people with large Social Security benefits. But that’s not a good reason to claim Social Security early and reduce monthly benefits.

For many people, it’s best to delay Social Security claiming until full retirement age or later. Waiting as long as possible to claim benefits reduces the chances of outliving your money while also maximizing survivor benefits (if you’re the higher earner).

While Social Security is part of a broader retirement income plan, taxes should be a secondary consideration. And remember, at least 15% of Social Security income is exempt from federal income taxes no matter what. Considering that benefit (and possibly exemption from state taxes), it doesn’t make sense from a tax standpoint to reduce your lifetime benefit and rely more on fully-taxable income.

In short, it’s worth evaluating the tax torpedo and considering strategies to avoid it. But don’t panic. With a little financial planning, it won’t sink your retirement.

This material has been prepared by T. Rowe Price for general and educational purposes only. This material does not provide fiduciary recommendations concerning investments, nor is it intended to serve as the primary basis for investment decision-making. T. Rowe Price, its affiliates, and its associates do not provide legal or tax advice. Any tax-related discussion contained in this material, including any attachments/links, is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any tax penalties or (ii) promoting, marketing, or recommending to any other party any transaction or matter addressed herein. Please consult your independent legal counsel and/or professional tax advisor regarding any legal or tax issues raised in this material.

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