# The Phantom Tax Rate Zone

by on September 25, 2012

In my last article, I wrote about Topping off your bracket with a Roth Conversion. Even as I posted it, I realized I missed a pretty large issue. You see, your Social Security benefits may be taxable if you:

• file a federal tax return as an “individual” and your combined income*is
• between \$25,000 and \$34,000, you may have to pay income tax on up to 50 percent of your benefits.
• more than \$34,000, up to 85 percent of your benefits may be taxable.
• file a joint return, and you and your spouse have a combined income*that is
• between \$32,000 and \$44,000, you may have to pay income tax on up to 50 percent of your benefits
• more than \$44,000, up to 85 percent of your benefits may be taxable.
• are married and file a separate tax return, you probably will pay taxes on your benefits.

It took less than an hour for a reader to point this out, so it’s time for a deeper dive on how you might be retired, collecting Social Security and never quite see a 15% marginal rate. It’s tough to explain any algebra problem that has more than two variables. I can solve them easy enough, but verbalizing is tough. So, today we’re going to assume a single retiree is collecting \$20,000 per year in Social Security benefits. And for simplicity’s sake, no deductions other than the standard \$5,800, and of course, the \$3,700 exemption. Here’s where it gets good – I pull up a copy of TurboTax (disclaimer – I am a paid blogger at their site, but am not being paid for this article, I actually just love their software) and enter an IRA withdrawal amount. I do this in \$1000 increments, and for each thousand increase in IRA withdrawal, I note the increase in Federal Tax. If the tax table tell you that your marginal rate is 15%, but you see your tax go up by 22.5%, 27.75%, or an insane 46.25%, you’ve entered what I call the Phantom Tax Rate Zone.

When you look at the marginal rate table, a single person is expecting their bracket to be at 15% right up till a taxable \$34,500. It’s the nature of the phase-in of the tax on your Social Security benefit that makes your tax rise far more than this on the next incremental dollar withdrawn.

The question is whether you can use this to plan your retirement withdrawals a bit better. First, sit down and look at the numbers. If you are single and are actually going to collect \$20,000 in Social Security benefits, the chart above applies to you. If not, you’ll need to run some calculations of your own, and see where your phantom rates kick in. Next, how much do you have saved in pre-tax retirement accounts? For the above example, say it’s \$500K. That works out well, as the \$20,000 Social Security benefit is approximately what a \$50,000 earner would get at full retirement age, and the \$500K nest egg should offer you a \$20,000 per year withdrawal for a total \$40K per year retirement income. Now, that \$20K/yr withdrawal does hit the phantom 22.5% level, but no worse. It would take \$800K or more, and a \$32K/yr withdrawal  to push you into the much higher 46.25% rate. Here’s where it gets interesting. By delaying your Social Security start date, your benefit increases by 8% per year delayed. During this time, you’d take larger withdrawals from your 401(k) or IRA accounts, and, if you don’t actually need the extra funds, use the Roth Conversion to pull more money out of the accounts. Note, the numbers shown here is using 2011 rates as that’s the current software I’m using. When you add your exemption, standard deduction, and the \$34,500, you’re at a gross \$44,000 withdrawal and remain in the 15% bracket. 5 years of this withdrawal/conversion combination and you’ve drawn down your pretax account by over \$100,000, and increased your Social Security benefit by 40%.

I look forward to feedback on this, as I feel that the phantom tax rate, due to Social security being taxed at what I believe is a low threshold, is one of the most under-reported bits of financial news. It’s also a sad irony that one can work and remain in the 15% bracket, yet, if they save pre-tax and invested wisely, are doomed to pay 27.75% & 46.25% on a portion of their withdrawals. There are ways to avoid this, but only by planning ahead.

On Monday, I’ll reproduce the chart but for Married Filing Joint. Thank you to all those who have read this article.

Dave September 25, 2012 at 9:36 am

Great post Joe, thanks for addressing this. Another important point is that the thresholds for SS taxation you listed at the beginning are NOT indexed to inflation. Since many retirees income will rise with inflation, they will find themselves subject to more and more taxation throughout the years. Extrapolating out a couple of decades and many folks will find their SS benefits subject to tax even without any other income, unless the thresholds are changed.

I would love to see the MFJ table.

Grandma`s Goulash September 25, 2012 at 11:09 pm

Interesting analysis. After becoming suddenly disabled during my prime earning years and fifteen years ahead of my anticipated retirement date, I’d advise others to keep the possibility in mind, when doing financial planning.

Joe @ Retire By 40 September 26, 2012 at 4:10 am

I don’t understand how you get to 46%. I thought the top rate is 35%.
Anyway, that sucks. That’s why I like having Roth IRA and 401(k). They will give me more options when it’s time to withdraw.

joe September 26, 2012 at 7:42 am

Right, the marginal rates we know and love go 10/15/25/28/33/35. But, since Social Security becomes subject to tax above a certain level, there’s a different effective marginal rate. I did my best, via a graph, to show that by taking the Social Security benefit as a fixed number, which it is for any given year, and adding \$1000 increments (IRA or 401(k) withdrawals) to look at the change in the tax bill for each increment. When we get to an IRA withdrawal of 16K, \$500 of social security just became taxable, so the retiree for the extra \$1K withdrawn, now pays 10% on an extra \$1500. This person has a line 27 taxable income of \$7000, yet the last \$1000 cost \$150 in incremental tax.
The 46.25% is the effect of a 25% bracket combined with 85% of Social Security getting taxed. 25 x 1.85 = 46.25%.

This is such an important issue. And I am dumbfounded as to how/why it hasn’t gotten more attention. “Grandma withdraws \$35K/yr from her IRA, what bracket is she in?” 46.25%, sir! Joe, let me know if this made sense, maybe a snippet of the spreadsheet I used to create the chart would help?

Joe @ Retire By 40 September 26, 2012 at 11:08 am

Got it. Thanks for the explanation!

Adam September 27, 2012 at 7:46 pm

Joe, your explanation to Joe @ retire by 40 is wrong.

You take 25 x 1.85 = 46.25.

Really the equation should be: 25 x 0.85 = 21.25. Additionally the 25% you’re assuming is a marginal rate when someone’s effective tax rate in retirement is much closer to 15%

joe September 27, 2012 at 8:00 pm

Adam, what happens is that \$100 that would be taxed at 25% pulls in \$85 of Social Security which is also taxed at 25%. Slice it up and explain as you will, but the effect is the next \$100 withdrawn for Tradition IRA or 401(k) raises the tax bill by that \$46.25.

I assume nothing more than the \$20K Social Security benefit, the chart then ranges from \$10K to over \$40K to show the tax change. A \$20K benefit and \$30K withdrawal doesn’t seem outside the normal range of incomes.

Adam September 27, 2012 at 9:36 pm

Ahh I get what you’re saying now, I was wrongly focusing on just the SSI portion and not the income that goes along with it.

joe September 27, 2012 at 9:43 pm

Adam – the process and discussion are pretty technical and tough to explain. Thanks for hanging in there.

Kelly September 28, 2012 at 10:02 am

The marginal tax rate applies to marginal dollars not all dollars.

joe September 28, 2012 at 10:11 am

Exactly, Kelly. Sorry this is still confusing some readers. Thought my reference to Marginal Rate article would permit me to skip the detailed explanation.

Adam September 27, 2012 at 7:47 pm

Also your nontaxable interest only refers to Municiple bonds not interest in a Roth 401k/IRA. I confirmed this with the IRS.

joe September 27, 2012 at 8:02 pm

Fair enough. I assumed it went with saying (that transactions within these accounts are ignored) but nothing should just be assumed. I appreciate the clarification.

Adam September 27, 2012 at 7:55 pm

Also you’re incorrect to say that 1 dollar over the 44k limit immediately makes all of your SSI benefit 85% taxable. It is gradually phased in. For example if your benefit is 20k and you have 44001 of taxable income including interest from municiples.

Your taxable SSI benefit would be (34000-25000)*0.5 +(44001-44000)*0.8 = 4500.8

Review your calculations as they are largely incorrect.

20k – 4500.8 = 15499.2

joe September 27, 2012 at 8:40 pm

It’s clear both from my writing and the graph that it’s phased in, each incremental dollar having its own impact. If you look at the graph and read the article slowly, you’ll see there’s first a phantom 15% while one is in the 10% bracket, then a phantom 22.5% for the 15% money, etc. Nowhere did I suggest a dollar of income then makes all SS taxable. It’s phased in, per the graph.
By the way, the calculations weren’t done by hand, as I noted, I sat with TurboTax, and incremented the IRA withdrawal by \$1000 at a time to produce the tax due. The chart came from those numbers.

Dave September 28, 2012 at 5:08 am

Adam, Joe’s calculations are correct. The graph is titled “marginal rate”, which is the tax rate on the last dollar of income. Marginal rate is the key driver in whether to earn the next dollar of income or make the next dollar of Roth conversion.

That extra dollar that you earn or convert which puts you over the 85% threshold cause 85 cents of SS to be taxable. If you are in the 25% bracket you pay 25% tax for the extra dollar plus 25% of the 85 cents in SS, which effectively is the same as if you had a 46.25% marginal tax rate.

Roger @ The Chicago Financial Planner September 30, 2012 at 9:05 am

This is very scary and I’ve seen a couple of cases where retirees are doing things that they think will reduce their taxes on their Social Security such as investing in muni bonds that actually worked against them. I think this analysis is part of what I describe to retirees as the “…myth of the lower tax bracket in retirement…”

joe September 30, 2012 at 9:10 am

Much thanks for the visit and thoughts, Roger. I’m now working on the MFJ version of this article, and a follow up to discuss the better ways to avoid this.

Stevie November 4, 2016 at 9:36 pm

This doesn’t get the coverage it deserves in general media. Could argue for delaying SS to maximize benefit to minimize tax torpedo, because half is always tax free.

Joe November 5, 2016 at 5:03 am

Thanks, Steve! I need some time, but am sketching out an example of how spending down your savings during the 8 years will boost the SS benefit as well as lower its taxation, potentially to zero. I hope to publish within a few weeks.