Have you heard of the tax torpedo? It’s real – and it’s real scary.
Your Social Security benefits will likely be subject to income tax if you have other income such as wages, self-employment income, capital gains, or taxable interest and dividends. This may also be true if you have a substantial pension or take taxable distributions from a traditional 401K or IRA – and at some point you are required to take minimum distributions from those retirement plans.
The calculations are complicated, but when you begin collecting Social Security and your taxable income from all sources is above approximately $70,000, you must pay income tax on 85% of your Social Security benefits. You may previously have been enjoying paying less or no tax on your social security benefits but when one taxable event happens that pushes you over the limit, you’ll be paying much more income tax due to the taxation of your social security benefits.
Under current tax law, if you’re married filing jointly and your taxable income goes above about $81,000, you will also jump from a 12% tax rate to a 22% tax rate on the taxable income over that amount (to about $172,000 when it increases to 24%). At about the same time, your tax on capital gains and qualified dividends will go from a 0% tax rate to a 15% tax rate.
These additional income taxes can make a big difference in the amount of money you will have to live on. Thankfully, there are strategies you may be able to employ prior to the time you begin taking Social Security that can reduce or eliminate the tax torpedo. It’s important to plan for this as soon as possible but if you’re retired and not yet taking Social Security, it may not be too late. Avoid the tax torpedo!