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Federal Employee Financial Planning: Social Security: The Tax Torpedo (EP38)

In this episode, John, Tommy, and Ben delve into the intricacies of the Tax Torpedo and its impact on the taxation of Social Security. The Tax Torpedo is appropriately named because it has the potential to sink your tax situation if you're not vigilant and attentive to its effects. Typically, individuals who solely rely on Social Security income do not have taxable income, meaning they don't need to file a tax return. Things get more complicated when you have additional sources of income such as dividends, interest, and IRA distributions, as these factors can significantly impact your tax liability.

You will learn the importance of diversifying your tax allocation, favoring options like Roth IRAs and even IRAs if the situation is right, as well as why flexibility is crucial. The Tax Torpedo serves as evidence that the program is already means-tested and subject to additional taxation based on an individual's income level. While it's crucial to acknowledge these challenges, it's important to recognize the existing factors that are already impacting the taxation of Social Security.

Listen to the full episode here:

What you will learn:

  • How the tax torpedo actually works. (3:00)
  • What happens to your taxes when you have Social Security plus other income sources. (5:40)
  • What bracket topping is. (8:30)
  • The importance of having diversification in our tax allocation. (11:30)
  • How to avoid getting a surprise tax bill in the future. (14:00)
  • The benefit of planning for your taxes effectively. (16:45)

Ideas worth sharing:

  • “The tax torpedo is appropriately named because it can really torpedo your tax situation if you are not careful and paying attention to it.” - Mason & Associates, LLC  
  • “If you have Social Security income plus dividend income, plus interest income, plus IRA income, that's where these situations can get really tricky. And when you add these other income sources, it actually might be a dollar of income that you receive in your pocket, but it is an additional dollar and 85 cents of taxable income.” - Mason & Associates, LLC  
  • “Diversification in our tax allocation is important. It allows us flexibility because we don't know what might happen to us in the future or what card we might be dealt.” - Mason & Associates, LLC  

Resources from this episode:


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Read the Transcript Below:

Congratulations for taking ownership of your financial plan by tuning into the Federal Employee Financial Planning Podcast, hosted by Mason & Associates, financial advisors with over three decades of experience serving you.

Tommy Blackburn: Welcome to the Federal Employee Financial Planning Podcast. Thank you for being with us.

And today's episode is hosted by John Mason, certified financial planner; Tommy Blackburn, CFP and Certified Public Accountant; and Ben Raikes, CFP and IRS Enrolled Agent.

Mason & Associates has over three decades of experience helping federal employees with their financial plans.

In today's episode, we're going to be talking about, I believe it's now, Social Security Part 4 that we're on. And we're going to zero in on one of the areas that we think is kind of fun and important to be aware of. What's called the Tax Torpedo. We're going to really dive into the taxation of Social Security.

John Mason: Well, guys, I sure hope this is the last episode of Social Security. As we keep recording these, we just realized there's so much content. So, hopefully, Tommy Blackburn, as you said, this is the last one.

And then shout out to Mike Mason and Ken Mason, not only the founders of the firm, Mike is a big part of this podcast as our audience knows. Sad, he can't be with us today, as he is feeling a little under the weather.

So, Mike, when you listen to this, hopefully we do it justice. We miss you. And we'll see you on a future episode.

To our audience, welcome back. For those of you who have been tuning in every two weeks, listening to these episodes and waiting for this content to come out.

If this is your first time checking out our podcast, we're financial planners first, we're content creators second.

As Tommy mentioned, we have over three decades of experience serving federal employees and we'd love the opportunity to serve you as your financial planner.

And the process to start with Mason & Associates is going to our website, and requesting an introductory phone call.

Tommy Blackburn: So, guys, if we can jump into today's episode, let's think about it. We have a client, they're receiving only Social Security. We'll assign some numbers as we go. They call in to their other financial planner and they say, “I need $10,000.”

And they say, “Hey, Mr. and Miss client, you are in the 12% bracket, so we'll just withhold 12% on 10,000.” That's how it's going to work, right?

John Mason: Wrong, baby. That is not the answer that you're looking for. And in fact, that's actually, Tommy, more dangerous than the answer you would get from most 401(k) providers or TSP providers because-

Tommy Blackburn: They just wouldn't answer.

John Mason: They just say, “I don't know, man, you got to consult your tax advisor. I can't help.” The worst answer was somebody who thought he was doing you a solid, somebody who thought he was helping, who actually gave bad advice.

So, Ben, in Tommy’s example, why? Well, number one, we know why TSP I guess they were right and wrong to bail out. But in Tommy's example, what did this man or woman have wrong?

Ben Raikes: What they didn't account for is a concept that I think we've talked about before and we've been alluding up to it in the previous episodes when we were talking about Social Security.

But this is a concept called the Tax Torpedo. And honestly, it is appropriately named because it can really torpedo your tax situation if you are not careful and paying attention to it.

Essentially, what happens is if you are someone who is receiving all Social Security income, chances are highly, highly likely that if that is your only income source, you will not have any taxable income.

Tommy Blackburn: I think it's more than just highly likely. I think if all you have is Social Security under today's maximum benefit, you're not going to owe any tax.

Ben Raikes: What was the number we came up with, John, beforehand?

John Mason: Yeah. We were just playing with this. And we said this on a past episode, the maximum benefit you can have this year, if you delayed all the way until age 70 is 55,000.

So, if you have two people making $55,000 a year on Social Security, they don't even have to file a tax return because they don't owe any taxes. And that's a factor of the rules on taxation of Social Security.

How you get there is you calculate something called provisional income. Provisional income then tells us how much of Social Security flows over from line 6a on the 1040 to line 6b. So, how much actually flows through and is subject to federal income tax.

And that example, 55K each, they don't even have to file a tax return. We used Holistiplan, our tax projection software and we put in $150,000 of Social Security income.

And in this example, the couple would've paid like $200 in federal income tax.

Ben Raikes: It is amazing the way that Social Security taxation works. $150,000 of Social Security income and essentially receiving no tax.

And to Tommy's point, there's probably not a person on the planet that is earning that much Social Security income. So, we can confidently say, if all you have is Social Security income, you will not be taxed.

To get to the point, what we are talking about with the Tax Torpedoes, if you have Social Security income plus dividend income, plus interest income, plus IRA income, that's where these situations can get really tricky.

And when you add these other income sources, it actually might be a dollar of income that you receive in your pocket, but it is an additional dollar and 85 cents of taxable income. And John, maybe you can shed some more light on that.

John Mason: Well, Ben, you did a wonderful job explaining. So, you've got that provisional income formula that basically says take half of my Social Security and then add in what we would call bad money.

So, bad money are all those things you just said. And federal employee retirement system pension and CSRS pension, this is all bad money.

So, for our federal employee listeners, they're not going to be 9 times out of 10 in a situation where none of their Social Security is taxable. Why? Because they have RMDs from Thrift Savings Plan, because they have big federal pensions.

So, they're going to find themselves in an area where it's not like we make 60,000 of Social Security and none of it flows through to my tax return. It's going to be like we have 60,000 of Social Security and 40,000 flows over to the tax return. So, that bad money, every …

And then Tommy, your example, you said, “I call my financial planner, I'm taking 10,000 out of my IRA, how much do I need to have withheld in taxes?”

Well, that 10,000 IRA distribution may have increased this person's income by 18,500 because of the Tax Torpedo.

Tommy Blackburn: Yep. So, it just ain't so what you think it is on the surface, and we could easily, instead of being in a 12%, we're probably what, at least in a 18%. We could find ourselves in a 40% because each dollar is pulling in that phantom Social Security income along with it.

You don't feel any cash flow richer, but that Social Security is slowly becoming more taxable. So, we can get into one, our withholding could be way off if we just look and think, “Oh, we're in the 12% bracket.” But actually we're really maybe incurring taxes at a 40% rate.

So, we need to be aware of this. And maybe we'll even go into kind of what do we think we do in these situations?

And the reason I pause as I was thinking about it, as John mentioned, it's pretty rare to be in this situation, I guess, particularly with a federal retiree because you have pensions. You kind of already blew through the Tax Torpedo typically.

But what are some things we think about when, “Okay, we've identified the situation, Mr. and Miss client. This isn't exactly the tax situation we want to be in on this next distribution. We know we're going to need to withhold more.”

But maybe what are some other things we think about when we approach this situation?

John Mason: Tommy, I think your question leads me to what I would call like bracket topping is what pops into my mind. I know we've talked about this concept on a past episode.

But when I think of bracket topping, I think of increasing my income by doing a Roth conversion or realizing some additional capital gains.

So, like in a year, where I've already blown through the Tax Torpedo with a client, I'm going to be looking for other ways to create income. Doing Roth conversions, realizing capital gains, selling a rental property, because we've already made it through this nasty zone.

As long as I'm not pushing them to another tax bracket from 22 to 24 or I haven't increased their Medicare premiums, I'm going to try and bracket top and kind of just like if you're going to blow through it, go through it, baby, don't just stop.

Tommy Blackburn: You just said what was coming to my mind. If we find ourselves, if we're going to be in that Tax Torpedo, let's just say it's in that 40% nasty range. Well, you know what they say when you're going through fire, don't stop.

John Mason: Keep on going.

Tommy Blackburn: Keep going, get through it, get to the other side where it's a sunnier picture. And then really we probably want to stop and think, John, like you were saying, bracket topping.

Or I think another way I think about is I don't want to be in this situation every year.

So, maybe now, let's take some income at now, we're back down to the 24%. Let's build a bucket of money that we can go to in future years that we don't find ourselves in this situation.

Ben Raikes: And so, just to clarify a little bit for the listeners out there, what you all are talking about is we have these standard tax brackets, which are what, guys? Help me out with the tax brackets.

John Mason: 10%, 12%, 22, 24, 32.

Ben Raikes: And when we're in that Tax Torpedo, we don't just step up bracket by bracket technically, do we? What happens is you'll go from a 12% bracket jump all the way up to where again, you're adding a dollar and 85 cents of taxable income for every dollar of income you paid yourself.

So, that 12% essentially doubles to 24 or even greater immediately. Once you blow through that Tax Torpedo range, you'll actually see your marginal tax bracket drop.

John Mason: Now, Ben, you said it so well.

And at our presentation we did a few weeks ago, where we were presenting on Social Security to an audience here locally, we even made the point that a lot of retirees don't even have a 10 or 12% tax bracket because of how the Social Security taxation works is because of this Tax Torpedo, they find themselves instantly in the 22% or higher.

Which takes us to our next point and, Tommy, you said this too, is we find ourselves in this position. We find ourselves in this torpedo range in a 40% or higher tax rate.

Wouldn't it have been nice to know at 55 years old that you were going to end up there? And wouldn't it have been nice to know at 45 years old that you're going to end up there?

I remember a financial plan I did for somebody non-federal who only had Social Security and what they've saved (most of America). And we were looking at what this family was doing pre-tax or Roth.

And we looked at their tax bracket and was like, “We should emphatically be doing Roth IRAs. They're in the 15% bracket. Why would we not do Roth IRA, Roth 401(k)?”

Well, then we went to their retirement plan and we looked at Social Security. I started doing some math on the provisional income and I found out that we could extract 10 to $15,000 from a 401(k) every year tax free and keep Social Security tax free.

So, why pay taxes on Roth 401(k) if I already know 10 years from now, I can get back to my pre-tax money tax free.

Tommy Blackburn: It's because of what you don't know that's going to happen. It's because maybe we were going to extract 15,000 but then a roof broke, we had to replace a car.

So, we talk about having diversification in our tax allocation. That's why we like, I mean, we're very passionate about Roth IRAs and maybe even IRA given the situation.

But to me, that's where having flexibility because we don't know what might happen to us in the future, what card we might be dealt.

Being able to go to a bucket with a different tax characteristic, that's where it's very helpful. It's for life's unknowns. You just don't know what's going to come at you every single year.

John Mason: It is nice to have a mix of those assets both pre-tax and Roth, and knowing that this torpedo is coming and having a plan for it, and proactively doing conversions or what have you, so that we don't end up in this spot.

Because it really derails a financial plan where you defer taxes. I shouldn't say … that's strong. It's more of just like insulting.

Tommy Blackburn: It's insulting, for sure.

John Mason: It's insulting. It's like I deferred my taxes of TSP at 22% and Tommy just showed me Holistiplan where I'm in a 45% marginal tax rate and I haven't even brought in Virginia yet.

Ben Raikes: Guys, they don't make it easy for us to make these calculations on our own. Social Security is taxable at 0% or up to 85% based on all of your income sources.

I know the three of us sitting in this room have a good grasp on the numbers and we have software that helps us think of all these things.

But if you're someone who's receiving Social Security income now, and maybe you have a small pension, or interest, or dividends, the call to action is to really call someone like us and make sure that your tax plan is set, that your tax plan is straight.

What you'd hate to see is exactly as Tommy said, “Okay, I'm receiving Social Security income now, and I need to replace my roof. I took $10,000 from my IRA and I think I withheld enough.”

Maybe you didn't, maybe you need to take a look at that situation again and call somebody to make sure that you don't get a nasty tax surprise come April.

John Mason: Well, Ben, I think continuing down this path because we could go on and on about taxes, and planning, and look into the future, but what sparked in my mind as you were going through your statements there is that just having a plan in place.

And I think we've all seen with clients that they celebrate when their tax bill come April 15th is low. And what I mean by tax bill is amount of federal tax paid versus owed. And if they owed $0 slash their required amount was zero, they're very happy.

They're like, “Ben, I have all this Social Security, I didn't take any money out of my IRA, and I didn't have to pay any taxes. This is wonderful.”

Well, what would've been wonderful is to be proactively saying to that client, Mr. and Mrs. Client, your base case on your tax return is you're not going to owe any federal or state income tax this year.”

“But based on my projections, we can do a $30,000 Roth conversion and you still won't owe any income tax. So, why don't we do that too?”

“And oh, by the way, if we do a $45,000 conversion, it'll only cost you a $1,000 in federal income tax. Let's convert 45,000 and pay some taxes this year because look what's going to happen in the future.”

Tommy Blackburn: Well, 100%. Because usually, you're being lawed into a load, into a false sense of security where you're, “Oh man, I'm in these low income tax shares. This is wonderful.”

And then low and behold, RMDs begin, life happens, and then we find ourselves in a situation where those low brackets where we could've done it at very little of realizing income, they're gone. Gone for good and now, our options are more limited in what we can do.

So, being able to say, “Hey, we are in this very low situation right now. Let's make hay.” Maybe let's think about this is not a usual situation, it's probably not going to happen.

We can reasonably project out into the future what is our tax plan going to look like? And then try to bake into some contingencies of maybe life happens, maybe tax rates change.

John Mason: So, couple maybe just assumptions that we should throw out because we've gone through a lot of numbers on this episode already.

When we say things like, “You're not going to owe any taxes,” and what have you, we're basing that on our understanding and the rules of provisional income.

So, if you have questions, our audience can Google provisional income or they can call us and we'll help you understand how that works. We are assuming a married couple throughout this episode, who's 65 or older, who has a standard deduction of almost $31,000 this year.

So, keep in mind, even though you may have some Social Security that's flowing through from 6a to 6b, we're still reducing that number by almost 31,000 for standard deductions.

Here's a call to action too, because it's almost tax time or it'll be tax time, (they'll have already filed taxes, our audience, when this airs) is to look at your 2022 1040, look at line 6a and then right across from that you'll see 6b.

If more than 50% flows over to B, you're in the Tax Torpedo.

So, here's the example. You have 60,000 on line A and 31,000 on line B. That means every additional dollar you pull out of TSP 85 cents more of Social Security is becoming taxable.

So, that's how you can do a quick spot check, guys. So, if more than 50% moves over from 6a to 6b, you found yourself in the torpedo.

Ben Raikes: And, John, all this talk about the Tax Torpedo and provisional income and all these different tests on how much tax am I going to owe on my Social Security, really made me think of the previous Social Security episodes we've talked about.

And we've talked about, well, is Social Security going to be there for me? And there's different taxes that people want to add to Social Security, maybe they want to get rid of the wage base.

Social Security, as we can see from the Tax Torpedo, is already means tested. This is essentially an additional tax on Social Security based on how much income you make.

So, it's not to belittle the point or to try to tell people that they shouldn't be potentially worried about what Social Security might look like for them, but there have already been plenty of things in place that are testing Social Security that are adding more tax dollars to that system. This Tax Torpedo is one of them.

John Mason: Yeah, the more you've planned and the more well you've saved, and the more income streams that you have, the higher taxes that you have the privilege of paying. Not only through the marginal tax rate, but through how much of your Social Security is taxed.

And then prior episode on IRMA, I-R-M-A, which is everybody's least favorite penalty, which is you also, have the privilege of paying more for your Medicare part B.

Because don't you know, Ben, that if you have more income streams, you're also, very unhealthy. Which means you should pay more for the same insurance that everybody else has.

Tommy Blackburn: Well, I think as we've said, fair is just a fairytale. And those points I think drive it home.

Another thing as we're talking about the Tax Torpedo and these income means testing. This is also, potentially a reason. So, we'll argue against ourselves all the time.

Here are reasons to delay Social Security, here are reasons to take it early. So, we have to balance all of these things in each individual plan.

But a reason to delay Social Security is to give us, is what I would say, beautiful tax planning window, potentially.

If we can minimize other taxable income, we can then do Roth conversions, which give us flexibility, allow us to realize income at a low rate. Number of factors have to be true there for that to make sense.

John Mason: Well, I'm smiling here as we're recording this because I thought what you were going to say is we argue against ourself. And one way you can avoid being in the Tax Torpedo is to make sure that your Social Security income is low as possible.

So, if you turn your Social Security on early, you're probably at not a risk really of being in the Tax Torpedo by the time you add in your FERS and your TSP, you've already blown through it so fast, maybe it's not an irritant.

Tommy Blackburn: And at that point, you wanted to have you like cut off your nose despite your face kind of. So, you have to weigh all of these things. If you can tell we have a lot of fun as we think through this and weigh the different factors.

This has been another fun episode, thank you to my co-hosts. This has been Social Security Part 4. And please join us, listen to our podcast, subscribe. We'll have more episodes coming.

I know we're planning to do one on dual federal employees and we have two employees, spouses that are federal employees.

Listen, we also, have an active YouTube channel now. Please go check it out. We're trying to put some videos out now, that are educational and have some fun and great content to them.

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The topics discussed on this podcast represent our best understanding of federal benefits and are for informational and educational purposes only, and should not be construed as investment, financial planning, or other professional advice.

We encourage you to consult with the office of personnel management and one or more professional advisors before taking any action based on the information presented.