Understand the tax torpedo that accompanies Social Security

It was 2016. My wife and I wanted to take a family vacation, and we needed $5,000 to make it happen. Like a lot of retirees, we had some money in an IRA, so we took a distribution to cover the cost. We took the trip. It was a good one.

Then April came, and with it the tax return. There was a number on it that made me pause. We owed an additional $2,043 in taxes.

That wasn’t what I was expecting. The additional tax was far more than I’d planned for on a withdrawal of that size, on money we had already earned, from an account we had already paid into. It didn’t compute.

So I called our accountant. He was a good one. Careful, patient, honest. I asked him to explain how a $5,000 vacation had turned into a $2,043 tax bill. He looked at the return with me for a while, and then said something I’ve never forgotten.

That was his explanation. He did his best to say more. He talked about thresholds and phase-ins and something called MAGI. But by the end of the conversation I understood two things. The first was that he knew something was going on. The second was that even he couldn’t explain it in a way I could use. That answer sparked a curiosity I couldn’t let go of.

The three zones aren’t something I invented. They’re something I noticed. The tax code (written in 1983 and amended in 1993) produces this structure automatically. It’s there, in every scenario, for every Social Security recipient.

The first zone I called the No-Tax Zone. In this stretch, you owe little or no federal tax. The 1983 law included income thresholds below which Social Security benefits aren’t taxed, and those thresholds have never been adjusted for inflation. Today, the No-Tax Zone extends much further than it did when the law was written.

The second zone I called the High-Tax Zone. This is where many retirees find themselves without knowing it. In this zone, every additional dollar of income doesn’t just get taxed at your bracket rate. It also causes more of your Social Security to become taxable. So each new dollar of income adds $1.50 or $1.85 to your taxable income, not just $1. Your effective tax rate can be nearly double your bracket rate. This is where my $2,043 tax bill came from.

The third zone I called the Same-Old Zone. Once 85% of your Social Security has been pulled into taxable income, the compounding stops. From that point forward, additional income is taxed at your ordinary bracket rate, just as it would be for anyone else. The catch-up is finished.

Here’s what I want to emphasize, because it’s often misunderstood.

Not every retiree passes through all three zones. Where you are depends on two things: how much Social Security you receive, and how much other income you have. Someone with modest income might spend their entire retirement in the No-Tax Zone. Someone with substantial retirement account withdrawals might spend it entirely in the Same-Old Zone. The zones are the structure. Your particular situation determines which one you’re in, and what you can do about it.

Somewhere along the way, I got curious whether anyone else had figured this out. After a while, I found a paper published in 2014 in the National Tax Journal, by Leonard Burman of the Urban Institute, Norma Coe of the University of Washington, Kevin Pierce of the Internal Revenue Service, and Liu Tian of Syracuse University.^[1]

Four professional economists, working with actual tax return data, had arrived at exactly the same numbers I had with graph paper at my kitchen table. The effective tax rates. The 46.25% ceiling. All of it, confirmed.

Relief, mostly. I hadn’t been wrong. But also bewilderment. If this was known, why had no one ever told me? The academic paper is precise and careful, but it isn’t something an ordinary retiree could pick up and use. My graph could be.

— Bob

[1] Burman, Leonard E., Norma B. Coe, Kevin Pierce, and Liu Tian. “The Effects of the Taxation of Social Security Benefits on Older Workers’ Income and Claiming Decisions.” National Tax Journal 67, no. 2 (June 2014): 459–85. https://doi.org/10.17310/ntj.2014.2.07.

What has followed has been the most unexpected part of this whole project for me.

Grandpa and I have spent hours at the same kitchen table where he first sat down with the tax return in 2016. I bring my laptop. He brings his graphs. He explains the math, I ask the kinds of questions a smart outsider asks, and we both learn things we didn’t know before. My partner has worked alongside us too, double-checking the calculations so the tool holds up to the same standard Grandpa held his own work to.

Together, we’ve turned his hand-drawn graphs into something a retiree can use on their phone. We’ve built an educational website. We’re launching The Guetschow Graph through Halo Family Finance, so that no one has to figure this out from scratch the way Grandpa did.

What we’ve built so far is the educational side. Articles that explain each of the three zones. The graph itself, drawn and annotated for anyone to look at. And a calculator that takes two numbers (your Social Security benefit and your taxable income) and tells you which zone you’re in, what your effective tax rate is, and where the catch-up ends and your rate returns to normal. That much is done, and it’s free.

As people start using The Guetschow Graph, we’ll be listening to what they ask us next. There may be more we can build, but for now, the graph itself is what we have to offer. We think it’s enough to make a real difference.

Try the graph yourself →