As we matriculate through the dog days of summer here in paradise, many investors have turned their attention towards typical summertime activities like boating and the beaches. As relaxing as these activities may be, some retired investors turn their attention towards the new tax year.
Now, obviously, we could go on for days if we were to try and discuss and decipher the myriad of potential taxable events that can occur during the simple course of day to day money management. However, there is a little known taxable event fort many retired investors that can go completely unnoticed. In this case, we are looking at taxes on Social Security.
Not only are many not even aware of this event, but they almost never look for ways to address the issues so as to reduce or even, under certain circumstances, eliminate taxes due on this hard earned benefit. Perhaps the first variable we should address is the formula used to establish the tax rates on these benefits. The term is simply called “provisional income.” Our provisional income sets the rate for which the benefits will be taxed. There are three components which comprise provisional income; first is our adjusted gross income. This is the magic number our tax preparers arrive at on the bottom of the tax return after deductions, etc.
The next component added to the equation is 50 percent of our Social Security benefits. This number will depend on the tax filing of either joint or single filers. The third component to the equation is 100 percent of any tax free income, such as with municipal bonds. Yes, although this income is federally tax free on our tax return, they are the third and final component added to arrive at the final number establishing our provisional income. I know, it doesn’t seem fair but until changes are made to the tax code, this is how the math works.
Now that we have established our provisional income, we must look at the sliding scale by which the tax rate is established, again based on either filing tax returns jointly or individually. For instance, many file joint tax returns. The threshold for tax rates on Social Security based on provisional income is as follows; for provisional income between $32,000 and $44,000, up to 50 percent will be taxed. Income over the $44,000 threshold puts the tax rate as high as 85 percent. For single tax filers, the threshold to reach the 85 percent rate is provisional income above $34,000. In other words, expect anywhere from 50 to 85 percent of ones total Social Security income to be taxable.
Now, as odd as it may sound, one of the possible strategies to reduce the tax rate on these benefits may be eliminating such mundane investments such as bank CD’s. Yes, as innocuous as they may be from a yield standpoint, the reality is that income received from bank CD’s in non-IRA accounts pushes the provisional income up, even if these distributions are not wanted or needed for living purposes. The fact is that they are very much a component of the big picture.
Now, on the surface, we can mostly agree that retired investors own bank CD’s for 2 simple reasons; safety and liquidity. In light of the safety factor, it is important for investors to embrace that there are alternatives, insured and guaranteed alternatives, available for those CD type assets. I fact, the ability to replace the bank CD with an insured CD alternative can accomplish two critical objectives; First, the assets growing in an insured CD alterative can grow tax deferred, just like our IRA accounts grow…no tax bill each year until we spend the money.
The elimination of this CD tax bill can be a powerful tool in reducing our provisional income, which can reduce taxes on Social Security. The other benefit is the fact that in most cases, these insured CD alternatives will generally have a much higher yield. Combining higher yield, more money and less tax due certainly can lead to the life of a SWAN, Sleep Well At Night.
William F. Hague is a managing partner of Hague Wealth Management; 239-389-1999 or WFHague@earthlink.net. The opinions and observations stated above are those of the columnist.