Effect of provisional income on effective marginal tax rate

According to David McKnight, author of the Power of Zero, the name of the game in retirement is to get yourself into the zero percent tax bracket, as tax rates are likely to rise.  But what if tax rates remain the same ?  Is there a case for getting into the zero percent tax bracket, then ?  In this post, I will argue yes.

Let’s review the effect of provisional income on the percentage of social security subject to tax :

Tax Filing Status Provisional Income Amount of Social Security subject to tax
Single or head of household Less than $25,000 0%
$25,000 – $34,000 50% of the excess provisional income over $25,000
More than $34,000 50% of the excess provisional income over $25,000 + 85% of the excess provisional income over $34,000
Joint filers Less than $32,000 0%
$32,000 – $44,000 50% of the excess provisional income over $32,0000
More than $44,000 50% of the excess provisional income over $32,000 + 85% of the excess provisional income over $44,000

What isn’t immediately obvious is that as your provisional income (from non-social security sources) rise, it triggers a double whammy : firstly your tax rises at the rate that is determined by your taxable income; secondly it triggers additional income from social security that now must be counted as taxable.

This has the effect of increasing the marginal tax rate beyond what your tax bracket might suggest.  I call this the effective marginal tax rate.    Michael Kitces made the some observation.  This is the “tax bubble” he described in his post.  I set out to visualize the bubble, i.e. the increase in the effective marginal tax as provisional income (ex-social security) increases, in the graphs below.

ssn_36k_unnamed

The experiment assumed a social security benefit of $36,000, deduction and exemption of $20,000 and joint filing status.  I varied the source of provisional income (ex social-security) from $10,000 through $65,000.

As can be seen, the effective marginal tax rate is no longer monotonic with increasing income, and shockingly, can reach as high as 54.4% for income in the $30,000 through $48,000 range.  This means for every dollar between $30,000 and $48,000, 45.6 cents is taxed.

Let’s take a look at what the increase in the marginal tax rates look like with different amounts of social security benefits :

At $10,000 of social security benefits :

ssn_10k_unnamed

At $15,000 of social security benefits

ssn_15k_unnamed

At $20,000 of social security benefits :

ssn_20k_unnamed

At $25,000 of social security benefits :

ssn_25k_unnamed

What’s clear is that as the social security benefit increases, the range of provisional income that triggers the hyper inflated marginal tax rate of 54.4% gets wider.

In the examples shown where the sum of deductions and personal exemptions were $20,000, we would want to keep our provisional income (ex social-security) just at or below $18,000, and move other sources of retirement funding to tax-free vehicles funded with after-tax dollars (Roth IRA, LIRP).   If not, the amount you stand to lose in taxes increases with the amount of social security benefits you expect to receive.

Key take-away : even if tax rates remain the same, just by preventing social security from being taxed, one already comes out ahead, as the increase in effective marginal tax rate is avoided.

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