Minimizing the taxability of Social Security benefits.

• Author: Hammer, Seth

Social Security recipients may benefit from a variety of tax planning techniques that minimize the inclusion of such income. The primary objective in planning for the receipt of Social Security benefits is to minimize the multiplier effect, under which the generation of $1 of income can result in the inclusion of as much as $1.85 in taxable income. This article demonstrates the multiplier effect and discusses a variety of means to minimize it; tables, graphs and examples expedite the analyses and illustrate planning strategies.

Until recently, the rules governing tile inclusion of Social Security benefits and methods for minimizing their tax effects generally had not been of significant concern for many Social Security recipients (SSRs). The relatively modest thresholds for full inclusion of such benefits, combined with a limited range of feasible tax deferral mechanisms. often precluded the opportunity to do significant tax planning. Additionally, SSRs seeking to engage in part-time earnings activities have been further constrained by low annual earned income limits. The emergence of stock index funds as acceptable vehicles for investing and deferring income and the passage of the Senior Citizens Right to Work Act of 1996 (SCRWA), however, have created new opportunities for SSRs to minimize taxes and generate additional earned income.

This article presents a variety of methods for minimizing taxes on Social Security benefits. In general, these strategies are designed to meet two broad objectives:

1. Minimize the impact of the multiplier effect, under which the generation of $1 of of income can cause an increase of $1.50 or $1.85 in taxable income.

2. Avoid exceeding the annual earned income limits for SSRs; $1 of benefits is forfeited for every $3 ($2 if under age 65) of earnings in excess of the limit.

   Annual Earnings Limit

   Under SCRWA Section 102, amending Social Security Administration (SSA) Section 203(f)(8)(D),(1) effective in 1997, SSRs age 65-69 can earn up to $13,500 without triggering a reduction in benefits. The earnings allowance for these individuals is as follows:

   Earnings limit Year (age 65-69) 1997 $13,500 1998 14,500 1999 15,500 2000 17,000 2001 25,000 2002 30,000

   SSRs in this age group lose $1 in benefits for every $3 earned over the annual limit. The SCRWA did not affect the earnings allowance for SSRs under age 65; the 1997 limit is $8,640. SSRs under age 65 lose $1 in benefits for every $2 earned over the limit. SSRs age 70 and older are not subject to an earnings limit.

   Marginal Tax Brackets and the Multiplier Effect

   A central issue for the SSR contemplating generating additional income is to determine his marginal effective income tax rate. As discussed below, marginal Federal tax rates for an SSR's earnings generally can range from 15% to 51.8% (28% x 1.85 multiplier effect).(2)

   The starting point for determining inclusion of Social Security benefits is the computation of provisional income. Sec. 86(b)(1) indicates that "provisional income" is modified adjusted gross income (MAGI) plus one-half of Social Security benefits or Railroad Retirement Tier 1 benefits.(3) Sec. 86(b)(2) defines MAGI for this purpose as AGI plus tax-exempt interest, and excluding Social Security benefits, adoption assistance, foreign-earned income and housing allowances, savings bonds proceeds used for educational purposes and income from Puerto Rico and U.S. possessions.

   The marginal effective tax rate for individuals whose earned income exceeds the annual earnings limit may exceed the 51.8% rate because, in addition to the multiplier effect, there is also a gradual reduction in Social Security benefits. This combination of the multiplier effect and a reduction in benefits can lead to very high marginal effective tax rates for individuals who earn in excess of the annual limit. (The effective marginal tax rate can be over 100% for a self-employed individual under age 65.)

   Computing the Inclusion

   SSRs must include a portion of their benefits in income if provisional income exceeds the Sec. 86 thresholds; there are three different thresholds. Sec. 86(c)(1)(C) requires married taxpayers filing separately who do not live apart for the entire year to include a portion of their benefits in income regardless of the level of provisional income. Single taxpayers, heads of households and married taxpayers filing separately who lived apart from their spouse for the entire year are subject to a separate threshold, under Sec. 86(c)(1) (A); a third threshold, under Sec. 86(c)(1)(B), applies to married taxpayers filing jointly.

   Single Taxpayers

   The rules for Social Security benefit inclusion are as follows:

1. If provisional income does not exceed $25,000, Social Security benefits are not taxable (Sec. 86(b) and (c)(1)(A)).

2. If provisional income exceeds $25,000, but not $34,000, taxable Social Security benefits are the lesser of:

   (i) 50% of Social Security benefits or

   (ii) 50% of the excess of provisional income over $25,000 (Sec. 86(a)(1) and (c)(1)(A)).

3. If provisional income exceeds $34,000, taxable Social Security benefits are the lesser of:

   (i) 85% of Social Security benefits or

   (ii)the lesser of (a) $4,500 or (b) 50% of Social Security benefits, plus 85% of provisional income over $34,000 (Sec. 86(a)(2) and (c)(2)(A)).

   Example 1: J, a 68-year-old single taxpayer, projects he will receive $32,000 in interest income and $14,000 in Social Security benefits in 1997, and have $8,000 in itemized deductions. He is considering a $3,000 part-time job.

   Tax computation without job: Provisional income: Interest income $32,000 50% of Social Security benefits 7,000 Total provisional income $39,000 Taxable income: Interest income $32,000 Social Security benefits ($4,500 + (0.85 x $5,000)) 8,750(1) AGI 40,750 Itemized deductions (8,000) Personal exemption (2,60) Taxation income $30,100 Tax $5,224 Tax computation with job: Provisional income: Interest income $32,000 Wages 3,000 50% of Social Security benefits 7,000 Total provisional income $42,000 Taxable income: Interest income $32,000 Wages 3,000 Social Security benefits ($4,500 + (0.85 x $8,000)) 11,300 AGI 46,300 Itemized deductions (8,000) Personal exemption (2,650) Taxable income $35,650 Tax $6,778

   (1) J, with provisional income over $34,000, is subject to the following formula for the inclusion of Social Security Security benefits:

   The lesser of $4,500 or 50% of Social Security benefits (50% x $14,000 = $7,000) $4,500 Plus: 85% of provisional income exceeding $34,000 (85% x $39,000 = $34,000) 4,250 Includible Social Security benefits $8,780(*)

   (*) Inclusion amount cannot exceed 85% of Social Security benefits (85% x $14,000 = $11,900).

   The increase in tax generated by the $3,000 in part-time income is $1,554, an effective tax rate of 51.8%. Additionally, because the incremental income is from wages, J would also have to pay 7.65% in Social Security and Medicare taxes, which would raise the marginal tax rate to 59.45%, before taking into account any state and local taxes.

   Married SSRs Filing Jointly

   The rules for Social Security benefit inclusion are as follows:

1. If provisional income does not exceed $32,000, Social Security benefits are not taxable (Sec. 86(c)(1)(B)).

2. If provisional income exceeds $32,000, but not $44,000, taxable Social Security benefits are the lesser of:

   (i) 50% of Social Security benefits received or

   (ii)50% of the excess of provisional income over $32,000 (Sec. 86(a)(1) and (c)(2)(B)).

3. If provisional income exceeds $44,000...