What you need to know about how Social Security is taxed

Here is a practical example. My father sold his house for $300,000, which sum was subsequently invested at roughly 5 percent. His tax bill was small while he lived in his house. The $15,000 of interest earned was taxed at 15 percent. Unfortunately the additional interest income exposed an additional $9,750 of his Social Security benefits to taxes at 25 percent. In conjunction, his additional $15,000 of income created an incremental tax liability of $4,963, or 31 percent. That is a lot of money for someone who hadn't paid $4,000 in income taxes since he retired.

The change in his income also affected his eligibility for deductions and credits. The formula for medical deductions on the schedule A, for example, lowers the amount of your deduction as your income rises. Under today's tax code the reduction is 10 percent (for people born after 1949), or $2,475 in the case above. That translates into an increase of $600 in tax bill. Someone today in my father's situation would pay roughly $5,300 in additional taxes on the incremental income of $15,000.

Understand that these rules will affect a larger audience over time because of inflation. The threshold which triggers the tax dates back to 1983, when $25,000 had the equivalent buying power of roughly $59,800 in 2014. Separately, Americans have increased their reliance upon tax-deferred investments like 401(k)s which push past wages through a retiree's current income.  Bottom line, more people will pay the tax over time. 

IRS data confirms this trend. The number of returns with taxable Social Security benefits has more than tripled since 1990. In 2012, roughly 26 million income tax returns contained Social Security benefits. Of those, nearly 18 million returns contained taxable benefits, exposing more than 220 billion dollars of benefits to taxes and generating roughly 45 billion in revenue, which was returned to Social Security and Medicare.

To understand the anger, you have to strip away the side issues. People like my dad could not care less that you are taxing different revenue streams.  He does not care where the money goes. What he knows is that his income went up $1,000 and his tax bill went up $471. He knows that on Mitt Romney's worst day he pays 39.6 percent plus the 3.8 percent net investment tax on his income.

The future of these rules is predicted to get worse. The Congressional Budget office projects that "income taxes paid on Social Security benefits will rise from 6½ percent of those benefits in 2014 to more than 8 percent by 2024 and more than 9 percent by 2039." Furthermore, it reports that Congress is considering expanding these rules to all Social Security benefits making them even more onerous on the middle class.

It is no wonder that seniors fume. The government applies a means test that focuses the highest tax rates in the entire system on middle class income. These rules draw on savers who have demonstrated a distaste for taxes. These laws turn a system which was intended to alleviate poverty in the elderly into a system which fosters it.  It is a wonder why everyone isn't fuming.