The Retirement Tax Torpedo

Retirement should be a time to relax and enjoy the fruits of your hard work. However, many retirees are caught off guard by the so-called “retirement tax torpedo,” which can significantly increase taxes on retirement income. Before you proceed too far into retirement planning it is important to explore the ins and outs of this tax issue and examine a few strategies to help you avoid the pitfall of paying too much in taxes on your retirement income.

Read more: The Retirement Tax Torpedo

Understanding the Retirement Tax Torpedo

The retirement tax torpedo is a result of the complex calculation the IRS uses to determine taxes on retirement income. At its core, the tax torpedo is triggered by how Social Security benefits are included as part of your taxable income. There are three basic categories for individuals:

  1. None of your Social Security benefits are taxable.
  2. Between 1% and 85% of your benefits are included in taxable income.
  3. 85% of your benefits are taxable.

The retirement tax torpedo’s danger zone lies in the upper end of the first category, throughout the second category, and at the lower end of the third category.

Avoiding the Danger Zone

To avoid the retirement tax torpedo, you need to understand your numbers and take a strategic approach to your retirement income plan. The first step is to calculate your combined income, which the Social Security Administration uses to determine how much of your benefits are taxable. Combined income is calculated as your adjusted gross income, plus any tax-exempt interest, plus 50% of your Social Security benefits.

Once you’ve calculated your combined income, apply it to the threshold tables to determine what percentage of your Social Security benefits will be included as taxable income. Keep in mind that the higher your combined income, the greater the percentage of your benefits that will be taxed.

The threshold amounts and percentages for determining the taxability of Social Security benefits are as follows:

> For single filers, if your combined income is between $25,000 and $34,000, then up to 50% of your Social Security benefits may be subject to income tax. If your combined income is above $34,000, then up to 85% of your Social Security benefits may be subject to income tax.

> For married filing jointly, if your combined income is between $32,000 and $44,000, then up to 50% of your Social Security benefits may be subject to income tax. If your combined income is above $44,000, then up to 85% of your Social Security benefits may be subject to income tax.

A Real-World Example of the Retirement Tax Torpedo

To illustrate the retirement tax torpedo, let’s consider a married couple, Wayne and Lisa. They have the following retirement income streams:

Wayne’s full retirement age Social Security benefit is $3,000, while Lisa’s is $1,650, resulting in a combined gross monthly Social Security income of $4,650. In addition, they take $2,000 per month from their IRA, which amounts to $24,000 annually. The Social Security benefits total $55,800 per year, out of which only $12,715 is taxable due to their other income. As a result, their adjusted gross income becomes $36,715 (sum of IRA distributions and taxable Social Security). By subtracting the standard deduction of $30,700 (for taxpayers over 65), their taxable income becomes $6,015, leading to a tax liability of $602 based on the 2023 federal tax brackets.

Suppose Wayne and Lisa intend to purchase a new truck for $40,000 and withdraw the amount from their IRA. With about $800,000 in their IRA, they feel secure in taking out only 3% of their portfolio value. When calculating their tax liability, we need to add $40,000 to the $24,000 IRA distribution, leading to a total of $64,000. As a result, their taxable Social Security benefit increases from $12,715 to $46,715, and their adjusted gross income becomes a little over $110,000. After deducting the 2023 standard deduction, their taxable income rises to $80,015, leading to a tax liability of $9,162. 

The significant increase in their tax liability results from the fact that Social Security benefits are taxable on a graduated scale. As income rises, the amount of taxable Social Security benefits increases. In this case, the extra $40,000 withdrawn from the IRA caused an additional $34,000 of their Social Security benefit to become taxable income, resulting in an increase of $74,000 in their taxable income. Thus, for every dollar taken out of their IRA, their taxable income rose by $1.85, leading to what is known as the “retirement tax torpedo.”

Strategies for Lowering Retirement Taxes

You can use several strategies to reduce the impact of the retirement tax torpedo, depending on your financial situation, retirement accounts, and income needs in retirement. Some of these strategies include:

  1. Utilizing Roth IRAs: Distributions from Roth IRAs are not counted in your combined income, making them an invaluable tool for planning around taxes on Social Security. Consider contributing to a Roth IRA or converting a traditional IRA to a Roth IRA if you think you may be in the danger zone.
  2. Optimizing Retirement Income: Organize your retirement income to rely more on Social Security benefits and less on sources that are 100% taxable, such as IRA withdrawals. This could involve delaying Social Security benefits to increase your monthly payments while taking early withdrawals from retirement accounts.
  3. Structuring Withdrawals: Take your normal income from your IRA or 401(k) and fill up the 22% tax bracket with Roth conversions. Once you turn 70, continue to withdraw from your 401(k) or IRA up to the top of the 10% tax bracket, and then supplement the needed income from your Roth IRA. This can help keep your combined income below the retirement tax torpedo threshold. In addition to this strategy, there are numerous other combinations that can be used depending on your individual mixture of assets and income. 

Creating a Personalized Retirement Income Plan

The key to avoiding the retirement tax torpedo is developing a personalized retirement income plan that considers your unique financial situation, needs, and goals. Remember that everyone’s situation is different, and what works for one person may not work for another.

If you need help creating a comprehensive retirement income plan, we can help you.

The retirement tax torpedo is a complex issue that can significantly impact your retirement income and taxes. By understanding how Social Security benefits are included in your taxable income and implementing strategic planning, you can avoid falling into the danger zone and paying higher taxes on your retirement income. With a well-thought-out and personalized retirement income plan, you can navigate the retirement tax torpedo and enjoy a more secure and enjoyable retirement.

Remember, it’s not about avoiding spending your hard-earned money; it’s about having a plan that allows you to spend the money you want while minimizing the taxes you pay in retirement. The effort you put into planning your retirement income stream is well worth it, ensuring you can make the most of your retirement years. 

Retirement planning, uncomplicated.
Based in Texas | Serving Clients Nationwide
Start A Conversation
Copyright 2021. Carroll Advisory Group. All rights reserved.  Investment Advisory services offered through Strategic Financial Concepts, LLC. A registered investment advisor. Form CRS
crossmenu linkedin facebook pinterest youtube rss twitter instagram facebook-blank rss-blank linkedin-blank pinterest youtube twitter instagram