Watch out for the Social Security Tax Torpedo. It's a hugely unwelcome part of 1983 tax reform, which arrived when the Social Security Administration trust fund was running out of money. (Sound familiar?)
But there's an effective tax-planning strategy to steer clients out of the Torpedo's path.
Wade Pfau, professor of retirement income and director of the Retirement Income Certified Professional program at The American College of Financial Services, explores it in an interview with ThinkAdvisor.
Since the threshold for paying taxes on Social Security benefits hasn't been adjusted for inflation since about 1994, more and more taxpayers are — and will be — hit by the Tax Torpedo, Pfau says.
However, with an "aggressive" Roth IRA strategy, even folks with "a couple of million dollars in assets can avoid a big chunk of the Torpedo," he argues.
The goal is to have less taxable income later in life when receiving Social Security since once a worker begins collecting and their taxable income — from all sources — is above approximately $70,000, they must pay taxes on 85% of their benefits.
The Torpedo is "super-complicated," Pfau remarks.
People that have "relatively modest resources" should use the Roth conversation strategy, but "wealthier individuals may find that avoiding the Tax Torpedo impossible," he writes on his popular blog, Retirement Researcher.
In the interview, Pfau recommends that financial advisors start talking about the Tax Torpedo early in clients' retirement planning process.
Upfront planning is essential to employ his strategy, which needs to begin before the start of Social Security.
That time frame will be used to draw income from Roth accounts at a higher tax rate.
"Subsequent Roth distributions do not count when determining how much of Social Security is taxable," writes, Pfau, who is co-editor of the Journal of Personal Finance.
ThinkAdvisor recently interviewed Pfau, speaking by phone from his Dallas base. The prolific author has a new book due on Sept. 7. His "Retirement Planning Guidebook" embraces all the important retirement decisions, including those concerning Social Security, Medicare, tax efficiency — including, certainly, the Tax Torpedo — and more.
Here are highlights from our conversation:
THINKADVISOR: What's the Social Security Tax Torpedo?
WADE PFAU: It's super-complicated and a kind of trap.
Once your taxable income — including Social Security, IRA distributions, dividends, long-term gains from brokerage accounts, part-time or full-time work [etc.] — that is, any measure of income that goes on your Form 1040, is above approximately $70,000, you can't avoid the Tax Torpedo [kicking in]: You're going to be paying taxes on 85% of your Social Security benefits.
What's a concrete example?
Suppose you're in the 22% tax bracket. If there's a point where one dollar of income causes 85 cents of a dollar of your Social Security benefits to become taxable, then suddenly you're not in the 22% tax rate any more — you're paying more than 40% as a tax rate.
And if that also pushes a dollar of your long-term capital gains from the zero percent tax bracket to the 15% tax bracket, now [that] tax rate [goes up too].
You've said that in the future more people will be caught up in the Tax Torpedo. Why is that?
It's happening now. I think about half of retirees have to pay taxes on their benefits.
The main reason is that while most of the tax code is inflation-adjusted, the threshold for paying taxes on Social Security benefits hasn't changed since about 1994.
So every year, more and more people will be facing Social Security taxes just due to inflation.
Can't the government change the code to address that?
