Beware the Social Security 'Tax Torpedo': Wade Pfau

Watch out for the Social Security Tax Torpedo. It’s a hugely unwelcome part of 1983 tax reform, which arrived when the Social Security Administration trust fund was running out of money. (Sound familiar?)

But there’s an effective tax-planning strategy to steer clients out of the Torpedo’s path.

Wade Pfau, professor of retirement income and director of the Retirement Income Certified Professional program at The American College of Financial Services, explores it in an interview with BenefitsPRO’s sister publication, ThinkAdvisor.

Since the threshold for paying taxes on Social Security benefits hasn’t been adjusted for inflation since about 1994, more and more taxpayers are — and will be — hit by the Tax Torpedo, Pfau says.

However, with an “aggressive” Roth IRA strategy, even folks with “a couple of million dollars in assets can avoid a big chunk of the Torpedo,” he argues.

The goal is to have less taxable income later in life when receiving Social Security since once a worker begins collecting and their taxable income — from all sources — is above approximately $70,000, they must pay taxes on 85% of their benefits.

The Torpedo is “super-complicated,” Pfau remarks.

People that have “relatively modest resources” should use the Roth conversation strategy, but “wealthier individuals may find that avoiding the Tax Torpedo impossible,” he writes on his popular blog, Retirement Researcher.

In the interview, Pfau recommends that financial advisors start talking about the Tax Torpedo early in clients’ retirement planning process.

Upfront planning is essential to employ his strategy, which needs to begin before the start of Social Security.

That time frame will be used to draw income from Roth accounts at a higher tax rate.

“Subsequent Roth distributions do not count when determining how much of Social Security is taxable,” writes, Pfau, who is co-editor of the Journal of Personal Finance.

We recently interviewed Pfau, speaking by phone from his Dallas base. The prolific author has a new book due on Sept. 7. His “Retirement Planning Guidebook” embraces all the important retirement decisions, including those concerning Social Security, Medicare, tax efficiency — including, certainly, the Tax Torpedo — and more.

 Here are highlights from our conversation:

What’s the Social Security Tax Torpedo?

WADE PFAU: It’s super-complicated and a kind of trap. 

Once your taxable income — including Social Security, IRA distributions, dividends, long-term gains from brokerage accounts, part-time or full-time work [etc.] — that is, any measure of income that goes on your Form 1040, is above approximately $70,000, you can’t avoid the Tax Torpedo [kicking in]: You’re going to be paying taxes on 85% of your Social Security benefits.

What’s a concrete example?

Suppose you’re in the 22% tax bracket. If there’s a point where one dollar of income causes 85 cents of a dollar of your Social Security benefits to become taxable, then suddenly you’re not in the 22% tax rate any more — you’re paying more than 40% as a tax rate.

And if that also pushes a dollar of your long-term capital gains from the zero percent tax bracket to the 15% tax bracket, now [that] tax rate [goes up too]. 

You’ve said that in the future more people will be caught up in the Tax Torpedo. Why is that?

It’s happening now. I think about half of retirees have to pay taxes on their benefits. 

The main reason is that while most of the tax code is inflation-adjusted, the threshold for paying taxes on Social Security benefits hasn’t changed since about 1994.

So every year, more and more people will be facing Social Security taxes just due to inflation.

Can’t the government change the code to address that?

Yes. Most of the tax code is adjusted for inflation every year, and tax brackets go up. They could easily decide to do that for the Social Security tax threshold as well. I don’t know why they haven’t.

Is the Social Security Tax Torpedo something that FAs should be informing their clients about?

Yes. And an advisor trained in retirement planning — who has the RICP [Retirement Income Certified Professional] designation — definitely learns about this.

So tax-avoidance strategies for the Tax Torpedo should be addressed early in retirement planning, correct?

It certainly requires advance planning.

For instance, if you’re in your 60s and retired but delay Social Security to age 70 and go on an aggressive Roth conversion strategy, you might be able to get yourself set up so that once you start Social Security, even with a couple of million dollars of assets, you can avoid a big chunk of the Tax Torpedo.

Is Roth key to avoiding the Torpedo?

Yes. You’ll want to set up a Roth account. It doesn’t have to be super-large at the start. But during the early period, you’ll begin a strategy of aggressively converting to Roths. 

You can convert from a traditional IRA or with a 401(k) rollover.

So during that early period, you’ll be drawing all your adjusted gross income out of the tax-deferred account more aggressively at a higher tax bracket before you start Social Security.

After you start receiving benefits, you’ll try to keep your adjusted gross income lower, as from Roth distributions; proceeds from a reverse mortgage, life insurance, or the principal from your brokerage account — taxable income sources.

What’s a case that illustrates avoiding the Tax Torpedo?

I have this one in my book: If a [hypothetical] couple starts to claim Social Security and isn’t being very strategic about taxes, they would run out of money at age 88. 

But by being more strategic around tax planning and avoiding the Tax Torpedo, they wouldn’t run out of money then — they’d get six more years of retirement spending.

Would buying a QLAC — qualified longevity annuity contract — help in staying relatively clear of the Torpedo?  

That certainly can be part of the planning. You’ll have this taxable income source later in life, when by that point, you may have less taxable income.

[A QLAC] can be timed to help with the overall tax planning for your retirement. It all depends on the structure of your assets. 

For example, if you have everything in a Roth, you can have a huge net worth but no taxable income. So this isn’t just about net worth.

When did the Tax Torpedo first rear its head?

It began when the designers of the tax policy [came out with] the major tax reforms of 1983, when they started taxing Social Security benefits.

This was during the Reagan years. Alan Greenspan was head of the National Commission on Social Security Reform. It was when Social Security was running out of money. 

The solution was the combination of lowering benefits and increasing retirement age, which increased taxes. 

The government makes many significant decisions that affect taxpayers financially but about which they’re often unaware. Agree?

With Social Security, the Supreme Court ruled [in 1960] that people have no property rights to their Social Security benefits. They’ve been paying into the System their whole [working] lifetime but they haven’t any rights to their benefits [which therefore can be reduced or eliminated].