
6. Getting Blindsided by the Social Security Tax Torpedo
A terrifying moment for many new retirees arrives during their first tax season when they discover that the federal government taxes up to 85 percent of their Social Security benefits. This taxation is based on a metric called “provisional income,” which is calculated by taking your adjusted gross income, adding any nontaxable interest (such as municipal bond yields), and adding exactly half of your annual Social Security benefits.
If you are married filing jointly and your provisional income exceeds $32,000, up to 50 percent of your benefits become taxable. If your provisional income exceeds $44,000, up to 85 percent of your benefits become taxable. For single filers, the thresholds are even more punishing, starting at $25,000 and $34,000 respectively.
These tax brackets were established in the 1980s and 1990s and, cruelly, they were never indexed for inflation. Consequently, normal inflation naturally pushes middle-class retirees into these thresholds every year. Pulling money out of a traditional 401(k) or IRA increases your adjusted gross income, which in turn causes more of your Social Security to be taxed. This cascading effect is known in financial planning circles as the tax torpedo. Mitigating this requires drawing down taxable accounts prior to claiming benefits or executing strategic Roth conversions during your early 60s.
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