THE 46.3% MARGINAL BRACKET
Despite the new tax rate reductions of the Jobs and Growth Tax
Relief Reconciliation Act of 2003, the top marginal tax bracket
for many retirees is a whopping 46.3%. Why? Because Social
Security benefits are subject to income tax. Those affected are
Social Security recipients who have the good fortune
(misfortune?) to be subject to both the 25% income tax bracket
and the 85% inclusion rate for Social Security benefits.
Here's how it works. First, you must understand how Social
Security benefits are taxed. The income tax formula begins with
the calculation of combined income. For all practical purposes,
combined income equals adjusted gross income (not including
Social Security), plus municipal income, plus one half of the
taxpayer's Social Security benefit.
So far, so good. If a married couple's income is under $32,000
($25,000 for a single taxpayer), Social Security benefits are
not taxable. If combined income is between $32,000 and $44,000
(or $25,000 and $34,000 for a single person), the taxable amount
of Social Security equals the lesser of one half of Social
Security benefits or one half of the difference between combined
income and $32,000 ($25,000 if single). Up until now, it's not
too complicated.
Here's where the real fun begins. If the taxpayers' combined
income is over $44,000 ($34,000 if single), the taxable amount
of Social Security equals: the lesser of (1) 85% of the benefit,
or (2) the sum of 85% of combined income over $44,000 ($34,000
if single) plus the lesser of $6,000 ($4,500 if single) or the
amount of Social Security taxable under the old rules. Nobody
ever said new tax laws created tax simplification.
Here's how we come up with that 46.3% bracket. In order to
illustrate an increase in the marginal tax, you have to compute
taxable income. Taxable income, as we all know, is net of
allowable deductions and exemptions. The standard deduction
(that many retired people claim), personal exemptions and the
tax brackets are all adjusted annually for inflation.
Assume Hank is over 65, files single, utilizes the standard
deduction, and has total 2006 adjusted gross income (exclusive
of Social Security benefits) of $39,000 and receives $21,900 in
Social Security benefits. That makes his income $49,950 (39,000
+ (21,900 x .5)). He exceeds the threshold, so taxable Social
Security equals the lesser of (1) $18,615 (85% of $21,900), or
(2) the sum of $13,558 (($49,950 - $34,000) x 85%) and $4,500.
Since $18,058 is less than $18,615 the taxable amount of his
Social Security benefits equals $18,058.
That makes his final adjusted gross income $57,058 ($39,000 plus
$18,058). After he takes his 2006 standard deduction of $6,400
($5,150 + $1,250 for age 65 or over) and a personal exemption of
$3,300, his taxable income is $47,358. That puts him in the 25%
marginal tax bracket. If Hank's income goes up by $10 of taxable
income he will pay $2.50 in taxes on that $10 plus $2.13 in tax
on the additional $8.50 of Social Security benefits that will
become taxable. Combine $2.50 and $2.13 and you get $4.63 or a
46.5% tax on a $10 swing in taxable income. Bingo...a 46.3%
marginal bracket.
Check with your financial planner or tax advisor about how
changes in your investments and income can affect your overall
tax picture.
About the author:
Mr. Morris, a fee based Investment Advisor Representative with
Raymond James Financial Services, Inc., helps
401k participants get the
most out of their corporate plans.
