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Double Whammy: the Taxation of Social Security Benefits

This week, Gail explains how the government takes away a piece of your Social Security benefits.

Dear Friends,

Next time you want to inject a spark of life into an otherwise dull family get-together, just bring up the taxation of Social Security benefits. Then prepare to stand back and shut up.

I guarantee Granny's otherwise sweet demeanor will turn positively warrior-like, Uncle Harry will miraculously awaken from his post-dinner nap, hellfire and brimstone will be summoned, and words you thought your dear old relatives never even knew (much less uttered) will pour forth.

My husband's late Aunt Jay, God rest her soul, could entertain anyone within earshot for at least an hour about the injustice of having to pay income tax on what she had already paid tax on : her Social Security contributions.

Setting aside the fact that most retirees receive far more than they ever contributed, it seems patently unfair. Indeed, it violates the principle that you should not be taxed twice on the same income. Aunt Jay positively loathed this tax. I am convinced that this devout, church-going, God-fearing woman would have voted for Jeffrey Dahmer if he promised to repeal this it.

Don't hold your breath.

Based on the recommendation of a commission headed by Alan Greenspan, Congress first approved a tax on Social Security benefits back in 1983. At the time, there was concern that the Trust Fund would run out of money in a year or two. It was decided that up to one-half of a retiree's Social Security benefit would be taxable, but only if his/her income exceeded a "threshold" amount. The National Commission on Social Security Reform estimated that only 10 percent of recipients would be affected.

Then, in 1993, Congress added a second threshold and increased to 85 percent the amount of Social Security benefits that could be taxed. Here's how it works:

If you are receiving Social Security benefits, at tax time you have to perform an additional computation to come up with your "base amount" of income. First, figure your adjusted gross income. Then add any municipal bond interest you earned over the past year (you won't pay federal income tax on this, but it still counts toward your "base amount"), plus one-half of the Social Security benefits you received. (1)

If this number exceeds the threshold of $25,000 in the case of a single individual or $32,000 for a couple filing married/joint, then up to 50 percent of your Social Security benefit must be added to your AGI. This entire amount will be subject to income tax.

If your "base amount" is more than $34,000 (single taxpayer) or $44,000 (married, filing joint), as much as 85 percent of your Social Security benefit is added to your adjusted gross income.

In both cases, if you are married, but file separately, the "base amount" is $0. So, no matter how little Social Security you receive, at least 50 percent will be taxable. Period.

Here's the real tragedy: These threshold amounts have never been adjusted for inflation. While only 10 percent of Social Security recipients might have had to pay income tax on their benefits back in '83, that number is far higher now, simply because Social Security benefits themselves have gone up!

That's why I call this a "stealth" tax: Congress knows the tax on Social Security benefits is going to generate more money every year. It conveniently allows lawmakers to raise taxes without having to go on record and cast a vote.

The legality of taxing a portion of one's Social Security benefits was underscored just last week in a case decided by the Tax Court: "Dovid and Marcia L. Goldfarb v. Commissioner."

Marcia and Dovid had retired to Florida after Marcia left the Montgomery County, Maryland police department due to a work-related injury. In 2003, in addition to other income totaling $76,633, Marcia received $13,524 in disability benefits from the Social Security Administration.

Since "amounts received under workmen's compensation acts as compensation for personal injuries or sickness" are generally not subject to income tax, Marcia figured her Social Security checks were not taxable. Thus, her disability benefits were not factored into the income the couple reported.

Marcia and Dovid had also applied this same logic to the tax returns they filed for 2000, 2001 and 2002.

However, when the I.R.S. examined the Goldfarb's 2003 tax return, it sent them a "deficiency notice," stating that they had underreported their income. The amount: $11,495 — 85 percent of Marcia's Social Security benefits.

The Goldfarbs balked. They contested the I.R.S.'s claim on several counts: 1) They pointed out that disability benefits are not taxable. 2) They asserted that the "base amount" should be calculated separately for each of them and that Marcia's income should not be combined with Dovid's to determine whether her Social Security income is taxable. 3) Because the I.R.S. had not found anything wrong with the way they had figured their taxes in the three previous years, the Goldfarbs argued that this was tantamount to the I.R.S. "blessing" their method of calculation.

They lost.

Citing previous court decisions, the tax court pointed out that "Social Security disability benefits are not workmen's compensation." (The reason: you can qualify for disability benefits even if you are not injured on the job.) Thus, Marcia's Social Security checks must be included as "income."

Second, the court ruled that although the section of the Internal Revenue Code that deals with the taxation of Social Security benefits refers to "taxpayer" in the singular, sometimes a singular noun ("couple" or "crowd," for instance) encompasses more than one person and that this was "the evident intent of the statute."(2) The fact is, a couple who files jointly, is considered a single taxpaying unit, i.e. a "taxpayer."

Finally, the judges said that, in essence, just because the I.R.S. didn't catch a mistake you made on a previous tax return (or two or three), that doesn't mean the tax police are required to overlook this mistake on subsequent returns.

Bottom line: Marcia and Dovid were ordered to pay an additional $2,053 in income tax for 2003.

Still unknown: whether the Goldfarbs annoyed the I.R.S. so much that it will audit their previous tax returns and issue a "notice of deficiency" for the other years Marcia and Dovid miscalculated their income. Accountant Kathy Dettling, with the firm Pfeiffer and Binder in Mars, PA, says the Internal Revenue Service can review 7 years of tax returns — longer if fraud is suspected.

You might be thinking, "That's not fair! Those dirty rotten scoundrels!" On the other hand, if your reaction is, "Good! I may not like it, but if this is the rule everyone has to abide by, then the Goldfarb's don't deserve special treatment."

Or, perhaps your response is, "This law sucks. Congress never should have passed it and I'm going to do my darnedest to get it changed by the time I retire." (which means I have a very good idea of how old you are) (3)

Hope this helps,
Gail

P.S. To read more about the history of the Social Security tax visit the Social Security's Web site: www.ssa.gov/history/taxationofbenefits.html

(1) If you retired from certain jobs in the railroad industry, you also have to include what's called "Tier One Railroad benefits."
(2) IRC Section 86
(3) Retiree; Gen-Xer; Baby Boomer

If you have a question for Gail Buckner and the Your $ Matters column, send them to: yourmoneymatters@gmail.com, along with your name and phone number.