It’s common practice for retirees to proportionately withdraw funds each year from their taxable and tax-deferred accounts to limit their tax liability. However, clients should also be aware that such a strategy ignores their marginal tax rate—what they pay on every additional dollar of income, according to a leading expert on Social Security benefits.

And because proportional withdrawal strategies consider only the tax brackets, clients must navigate the rising and falling pattern of marginal tax rates in retirement, said William Reichenstein, head of research for retiree income at Social Security Solutions, which offers a software platform designed to help advisors and near retirees map retirement strategies.

“A key lesson is that the [marginal tax rates] for most retirees of financial advisors are substantially different from their brackets,” Reichenstein said at Financial Advisor's Invest In Women conference in Atlanta on May 3. “Retirees should factor in their MTRs, and not their tax brackets when they try to decide how to tax efficiently withdraw funds in retirement—where withdrawals in this case is interpreted broadly to include Roth conversions,” he said.

Reichenstein said that, for a wide range of incomes, the taxation of Social Security results in marginal tax rates that rise to 150% and 185% of the tax brackets for lower- and moderate-income households. He explained that the household's Social Security benefits included in a taxpayer’s adjusted gross income depend on their provisional income, or PI, which equals their modified adjusted gross income plus one-half of their Social Security benefits plus tax-exempt interest.

Different filing statuses, he noted, have different provisional income threshold levels for determining the taxable amount of Social Security benefits. For singles and heads of households, these threshold levels are $25,000 and $34,000, and for married couples filing jointly, they are $32,000 and $44,000. Also, for a single household, the amount of Social Security benefits included in adjusted gross income is the lowest of three amounts: 1) 85% of Social Security benefits; 2) 50 cents for each dollar of provisional income between $25,000 and $34,000, plus 85 cents for each dollar of provisional income above $34,000; or 3) half of Social Security benefits plus 85 cents for each dollar of provisional income above $34,000. The same format applies to a married couple, except that the provisional income threshold levels are higher: at $32,000 and $44,000.

To show what impact the taxation of Social Security benefits has on marginal tax rates, Reichenstein used the example of a single individual in a tax-free state with $32,400 in annual Social Security benefits—typical for a median income. (A similar example would apply to a married couple with $65,000 in annual Social Security benefits.)  

With $13,400 of non-Social Security income, the taxpayer’s provisional income is at $29,600, ($13,400 + 0.5[$32,400]). Based on the first provisional income threshold level for singles ($25,000), $2,300 of her Social Security benefits are included in adjusted gross income, which totals $15,700, Reichenstein noted. He added that “assuming she is at least 65 at the end of 2023, her standard deduction of $15,700 offsets this AGI,” which means her tax bracket and marginal tax rate are 0% for each dollar of non-Social Security income of $13,400 or less. That changes, however, as she adds to her non-Social Security income.

For each additional dollar of non-Social Security income between $13,400 and $17,800, an extra 50 cents of Social Security benefits are included in adjusted gross income, which increases her taxable income by $1.50, Reichenstein explained, noting that her taxes go up by 15 cents because she is in the 10% tax bracket. Her marginal tax rate is 15%, (10% times 1.50).

A non-Social Security income of $17,800 puts her provisional income at $34,000, the second provisional income threshold level. “So, from this point on, you are going to have situations where each additional dollar of non-Social Security income between $17,800 and $20,178 causes another 85 cents of Social Security benefits to be taxed,” he said. The taxpayer’s taxable income now increases by $1.85, which results in her marginal tax rate being 18.5%, (10% bracket times 1.85).

For each dollar of non-Social Security income between $20,178 and $38,408, another 85 cents of Social Security benefits get taxed. Because she hits the 12% tax bracket, her marginal tax rate jumps to 22.2%, (12% times 1.85). 

At non-Social Security income between $38,408 and $44,906, she is in the 22% tax bracket. So, each dollar causes another 85 cents of Social Security benefits to be taxed. This puts her marginal tax rate at 40.7%, (22% times 1.85).

At non-Social Security income of $44,906, she has reached the income level where 85% of her Social Security benefits are taxed, which is the maximum. This is the end of the tax torpedo, which refers to the income range where the marginal tax rate is 150% or 185% of the tax bracket, Reichenstein explained, noting that “at the end of the tax torpedo, her marginal tax rate on additional dollars of non-Social Security income falls sharply from 185% of her tax bracket" back to her regular tax bracket of 22%, that is, the income level where 85% of her Social Security benefits are taxable.

So, the taxation of Social Security benefits puts her marginal tax rate at 150% of her tax bracket for non-Social Security income between $13,400 and $17,800, and 185% of her tax bracket between $17,800 and $44,906, which is an income range of more than $27,000. And at the end of the tax torpedo, her total income is $77,306 (non-Social Security income plus her annual Social Security benefit). Reichenstein noted that many single clients of financial advisors have non-Social Security income that places them within this tax torpedo.

Reichenstein further said that while the taxpayer’s federal marginal tax rate at the end of the tax torpedo is 40.7%, based on 2023 tax brackets, that is scheduled to change in 2026 when the Tax Cuts and Jobs Acts expires. “We will go back to the higher tax rates 10%, 15%, 25%, 28%, and at that point the MTR on a wide range of income will exceed 40%,” he said.

“So, for somebody living in an income tax-free state, the federal-alone MTR at the end of the tax torpedo is scheduled to be 46.25% (the 25% bracket times 1.85). And if you live in one of the 40-plus states that have a state income tax, you very well could be paying 50% or more as your MTR, and this is not a high-income individual,” he said.

If the taxpayer wants to avoid being up against a 46.25% marginal tax rate later in her retirement years, Reichenstein suggests she first, delay her Social Security benefits and take withdrawals from her taxable accounts to meet her spending needs. In addition, she should make Roth conversions in these years. Since she has not begun Social Security benefits, her MTR on these Roth conversions will be the same as her tax bracket, he explained. And second, once her Social Security benefits have begun, she can take tax-deferred account withdrawals to the top of a low-tax bracket or required minimum distributions (RMDs), if larger, where her RMDs would be lower in this strategy due to the early-year Roth conversions. She could then take  tax-free withdrawals from her Roth account to meet the rest of her spending needs, he said.

“By making those Roth conversations in the early years, she could pay MTRs of 0% to 22%. These conversions would provide the Roth account balances, that is, the ammunition, that would help her avoid taking additional tax-deferred withdrawals later in retirement when they would be taxed at 46.25%,” he said.