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How Tax Planning Changes Through Four Stages of Retirement Part III - Social Security

How Tax Planning Changes Through Four Stages of Retirement Part III - Social Security

| August 31, 2020
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Have you been following our blogs on the different stages of retirement?

So far we have covered the first steps to understanding changes in tax planning during retirement, as well as explaining how to develop workable solutions to our retirement tax problem.

Now we are going to be moving into Social Security.

You may remember from part two of this series where we mentioned how you may be thinking, “Okay, my accounts may not be worth as much as I thought, but I’ll have a steady flow of benefits from Social Security to supplement my income and I’ll have Medicare to pay my health costs." 

However, the thing to remember when creating your retirement tax strategy is Social Security and Medicare have their own “tax traps” that you need to plan for as well.


I’m going to refer back to part one of our series where we had a little brain teaser involving Bill.

In the brain teaser, we discussed a 65 year old man named Bill. He had worked hard his whole life and had finally retired. Bill was spending his retirement going to more concerts than ever before!

Bill has $42,475 in taxable income which includes $25,000 of Social Security benefits this year. 

If you check the chart below, Bill’s $42,475 of taxable income puts him squarely in the 22% tax bracket because it’s more than $40,125 and less than $85,525.

Toward the end of the year, Bill decides to take an extra $1,000 out of his IRA for a trip to see Willie Nelson play in Austin. How much is he taxed on that extra $1,000?

So how much tax will Bill owe on the $1,000?

The logical answer, according to the chart, is that for every dollar of IRA money he pulls out, he pays $.22 in federal income taxes. Therefore, if he took out $1,000, he should owe $220 in federal income tax – 22% tax.

Simple enough, right?


He owes $407 in tax—a 40.7% federal tax rate on that income!

Thanks to the madness that is our tax code, and the unique formula that determines how your Social Security benefits are taxed, the real answer is that Bill owes $407 on that extra income.

Shocking, right? Almost to the point where it can’t possibly be true! I mean, if the top rate for a single person is 37%, and that rate doesn’t begin until he has more than $510,000 of taxable income, how can he pay a higher rate with much less income?

It doesn’t make any sense! But here’s the thing… It doesn’t have to. It is the tax code, after all.

So now, after refreshing on our brain teaser, we want to understand why he paid such a high tax rate on the extra money he took from an IRA to go on a concert road trip.

Remember, Bill has $38,000 of IRA income, part of his adjusted gross income of $56,525. And he has $25,000 of Social Security benefits.

That puts him squarely in the 22% bracket, and he takes the standard deduction. 

Yet, when he took that extra $1,000 IRA distribution, he got hit with a nearly 41% marginal tax rate ($407) on that $1,000!

Let’s break down how this actually happens. First, let’s remember, the only difference between our two scenarios here is that Bill has taken an additional $1,000 from an IRA – you see that in the “After concert trip” column he has $39,000 in IRA income.

So, we see in the example above that by adding that additional $1,000 of actual income, it increased both his AGI and his taxable income by $1,850. That means for every dollar of income he actually received, he’s being taxed on $1.85. Huh? How?

Here’s the deal… Depending upon how much other income you have, the amount of your Social Security benefits that are taxable varies.

For instance, if your other income is low enough, all of your Social Security benefits will be income-tax-free at the federal level. On the other hand, if your income is high enough, up to 85% of your Social Security benefits can be taxable at whatever your personal rate is. 

Bill finds himself in the latter scenario. At his current income after the concert trip, for every dollar that he takes out of his IRA, he not only adds one dollar of IRA money to his taxable income, but he must also add an additional $.85 cents of taxable Social Security benefits.

And if you add that up, that’s $1.85 taxable at his 22% rate for every one dollar of additional IRA income he actually receives. If you do the math on that, it comes out to a 40.7% REAL tax rate on the additional $1,000 income!

That’s the so-called “Social Security tax torpedo.” 

It can impact single filers and married couples with even fairly modest income during any stage of retirement. It’s one reason planning taxes in retirement is so important.


Let’s look at another aspect of Social Security and taxation and how people approach retirement. 

Now, during the go-go years stage, some people retire altogether. But other people enter into a sort of semi-retirement.

Sometimes, it’s a continuation of a previous job, just with fewer hours. Others use semi-retirement to explore an interest in a new field. Still others use semi-retirement to pursue non-paid, rewarding volunteer work.

So working in retirement can impact your planning and taxes in a number of ways: some good, some bad, and some downright ugly.


Let’s look at how working during these years can be a good thing.

Chances are you have researched what your Social Security benefit might be at various ages. But you may not know that your Social Security benefit is calculated using your highest 35 years of inflation-adjusted earnings.

Well, what if you started working late in life? Or what if you left work to raise children? You may not have 35 years of earnings history. Suppose you have only 28? Those remaining seven years count as big fat zeros when they calculate your benefits.

But there’s good news. Earnings at any age can help you increase your Social Security benefit. And thanks to how Social Security calculates benefits, replacing several years of zeros with even modest earnings can positively impact your benefits.


Now let’s look at how working during your go-go years can be somewhat bad if you’re already collecting benefits and unaware of the Social Security earnings limit that applies prior to reaching your full retirement age. Here’s how the rule works:

If you start Social Security – be it your own retirement benefit or spousal benefits – prior to the year you reach your full retirement age, for every $2 above a certain amount that you earn ($18,240 in 2020), Social Security will withhold $1 of benefits.

Keep in mind that we’re talking about EARNINGS here, like a W-2 salary or self-employment income, NOT pensions, interest, dividends, and capital gains. They don’t count and won’t reduce “early” Social Security benefits. 

For instance, let’s say that you earn $20,240 in 2020. That’s $2,000 over the limit. Therefore, under the $1 withheld-for-$2 earnings rule, Social Security would withhold $1,000 of your 2019 benefits. But these benefits are not truly lost. When you turn full retirement age your benefit will be adjusted to make it as if you had applied at full retirement age with respect to those withheld benefits. In other words, your benefit going forward will be a bit higher. Also, in the year you reach full retirement age, there’s a separate, higher earnings limit.


Ok, we’ve talked about the good and the bad, so now you get the “ugly.”

We’re here today to talk about taxes and retirement. But there are other taxes that you may face, too. For instance, while you’re working, you’re subject to the 7.65% Social Security and Medicare taxes, in addition to income tax. The self-employed pay twice that amount – 15.3% – to cover the employer’s contribution. 

Now, these taxes don’t go away if you’re working past your full retirement age, or even if you're collecting Social Security! Worse, if your go-go years earnings don’t make it into your top 35 years, those Social Security taxes go into the trust fund and don’t increase your benefit.

Now that you’ve learned a bit more on the tax traps with Social Security, keep a lookout for our next post on a few tax traps involved with Medicare

Have any questions? Send me an email to I’d love to hear from you!

Advisory services through Capital Advisory Group Advisory Services LLC and securities through United Planners Financial Services of America, a Limited Partnership. Member FINRA and SIPC. The Capital Advisory Group Advisory Services, LLC (CAG) and United Planners Financial Services are not affiliated.

The views expressed are those of the presenter and may not reflect the views of United Planners Financial Services. Material discussed is meant to provide general information and it is not to be construed as specific investment, tax, or legal advice. Individual needs vary & require consideration of your unique objectives & financial situation. Neither United Planners nor its financial professionals render legal or tax advice. Please consult with your accountant or tax advisor for specific guidance.

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