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Minimizing the taxability of Social Security benefits.

Social Security recipients may benefit from a variety of tax planning techniques that minimize the inclusion of such income. The primary objective in planning for the receipt of Social Security benefits is to minimize the multiplier effect, under which the generation of $1 of income can result in the inclusion of as much as $1.85 in taxable income. This article demonstrates the multiplier effect and discusses a variety of means to minimize it; tables, graphs and examples expedite the analyses and illustrate planning strategies.

Until recently, the rules governing tile inclusion of Social Security benefits and methods for minimizing their tax effects generally had not been of significant concern for many Social Security recipients (SSRs). The relatively modest thresholds for full inclusion of such benefits, combined with a limited range of feasible tax deferral mechanisms. often precluded the opportunity to do significant tax planning. Additionally, SSRs seeking to engage in part-time earnings activities have been further constrained by low annual earned income limits. The emergence of stock index funds as acceptable vehicles for investing and deferring income and the passage of the Senior Citizens Right to Work Act of 1996 (SCRWA), however, have created new opportunities for SSRs to minimize taxes and generate additional earned income.

This article presents a variety of methods for minimizing taxes on Social Security benefits. In general, these strategies are designed to meet two broad objectives:

1. Minimize the impact of the multiplier effect, under which the generation of $1 of of income can cause an increase of $1.50 or $1.85 in taxable income.

2. Avoid exceeding the annual earned income limits for SSRs; $1 of benefits is forfeited for every $3 ($2 if under age 65) of earnings in excess of the limit.

Annual Earnings Limit

Under SCRWA Section 102, amending Social Security Administration (SSA) Section 203(f)(8)(D),(1) effective in 1997, SSRs age 65-69 can earn up to $13,500 without triggering a reduction in benefits. The earnings allowance for these individuals is as follows:
 Earnings limit
Year (age 65-69)

1997 $13,500
1998 14,500
1999 15,500
2000 17,000
2001 25,000
2002 30,000

SSRs in this age group lose $1 in benefits for every $3 earned over the annual limit. The SCRWA did not affect the earnings allowance for SSRs under age 65; the 1997 limit is $8,640. SSRs under age 65 lose $1 in benefits for every $2 earned over the limit. SSRs age 70 and older are not subject to an earnings limit.

Marginal Tax Brackets and the Multiplier Effect

A central issue for the SSR contemplating generating additional income is to determine his marginal effective income tax rate. As discussed below, marginal Federal tax rates for an SSR's earnings generally can range from 15% to 51.8% (28% x 1.85 multiplier effect).(2)

The starting point for determining inclusion of Social Security benefits is the computation of provisional income. Sec. 86(b)(1) indicates that "provisional income" is modified adjusted gross income (MAGI) plus one-half of Social Security benefits or Railroad Retirement Tier 1 benefits.(3) Sec. 86(b)(2) defines MAGI for this purpose as AGI plus tax-exempt interest, and excluding Social Security benefits, adoption assistance, foreign-earned income and housing allowances, savings bonds proceeds used for educational purposes and income from Puerto Rico and U.S. possessions.

The marginal effective tax rate for individuals whose earned income exceeds the annual earnings limit may exceed the 51.8% rate because, in addition to the multiplier effect, there is also a gradual reduction in Social Security benefits. This combination of the multiplier effect and a reduction in benefits can lead to very high marginal effective tax rates for individuals who earn in excess of the annual limit. (The effective marginal tax rate can be over 100% for a self-employed individual under age 65.)

Computing the Inclusion

SSRs must include a portion of their benefits in income if provisional income exceeds the Sec. 86 thresholds; there are three different thresholds. Sec. 86(c)(1)(C) requires married taxpayers filing separately who do not live apart for the entire year to include a portion of their benefits in income regardless of the level of provisional income. Single taxpayers, heads of households and married taxpayers filing separately who lived apart from their spouse for the entire year are subject to a separate threshold, under Sec. 86(c)(1) (A); a third threshold, under Sec. 86(c)(1)(B), applies to married taxpayers filing jointly.

Single Taxpayers

The rules for Social Security benefit inclusion are as follows:

1. If provisional income does not exceed $25,000, Social Security benefits are not taxable (Sec. 86(b) and (c)(1)(A)).

2. If provisional income exceeds $25,000, but not $34,000, taxable Social Security benefits are the lesser of:

(i) 50% of Social Security benefits or

(ii) 50% of the excess of provisional income over $25,000 (Sec. 86(a)(1) and (c)(1)(A)).

3. If provisional income exceeds $34,000, taxable Social Security benefits are the lesser of:

(i) 85% of Social Security benefits or

(ii)the lesser of (a) $4,500 or (b) 50% of Social Security benefits, plus 85% of provisional income over $34,000 (Sec. 86(a)(2) and (c)(2)(A)).

Example 1: J, a 68-year-old single taxpayer, projects he will receive $32,000 in interest income and $14,000 in Social Security benefits in 1997, and have $8,000 in itemized deductions. He is considering a $3,000 part-time job.
Tax computation without job:

Provisional income:
 Interest income $32,000
 50% of Social Security benefits 7,000
Total provisional income $39,000

Taxable income:
 Interest income $32,000
 Social Security benefits
 ($4,500 + (0.85 x $5,000)) 8,750(1)
 AGI 40,750
 Itemized deductions (8,000)
 Personal exemption (2,60)
Taxation income $30,100

Tax $5,224

Tax computation with job:

Provisional income:
 Interest income $32,000
 Wages 3,000
 50% of Social Security benefits 7,000
Total provisional income $42,000

Taxable income:
 Interest income $32,000
 Wages 3,000
 Social Security benefits
 ($4,500 + (0.85 x $8,000)) 11,300
 AGI 46,300
 Itemized deductions (8,000)
 Personal exemption (2,650)
Taxable income $35,650

Tax $6,778

(1) J, with provisional income over $34,000, is subject to the following formula for the inclusion of Social Security Security benefits:
The lesser of $4,500 or 50% of
 Social Security benefits
 (50% x $14,000 = $7,000) $4,500

Plus: 85% of provisional income
 exceeding $34,000
 (85% x $39,000 = $34,000) 4,250

Includible Social Security benefits $8,780(*)

(*) Inclusion amount cannot exceed 85% of Social Security benefits (85% x $14,000 = $11,900).

The increase in tax generated by the $3,000 in part-time income is $1,554, an effective tax rate of 51.8%. Additionally, because the incremental income is from wages, J would also have to pay 7.65% in Social Security and Medicare taxes, which would raise the marginal tax rate to 59.45%, before taking into account any state and local taxes.

Married SSRs Filing Jointly

The rules for Social Security benefit inclusion are as follows:

1. If provisional income does not exceed $32,000, Social Security benefits are not taxable (Sec. 86(c)(1)(B)).

2. If provisional income exceeds $32,000, but not $44,000, taxable Social Security benefits are the lesser of:

(i) 50% of Social Security benefits received or

(ii)50% of the excess of provisional income over $32,000 (Sec. 86(a)(1) and (c)(2)(B)).

3. If provisional income exceeds $44,000, taxable Social Security benefits are the lesser of:

(i) 85% of Social Security benefits received or

(ii) the lesser of (a) $6,000 or (b) 50% of Social Security benefits, plus 85% of provisional income over $44,000 (Sec. 86(a)(2) and (c)(2)(B)).

Excess Earned Income

If an SSR's earned income exceeds the annual earnings limit, there may be a substantial increase in the marginal effective tax rate. The severity of the effect depends primarily on whether (1) the taxpayer has been subject to a full phase-in of includible Social Security benefits, (2) the taxpayer is under age 65 and (3) the earnings are self-employment (SE) income.

Example 2: L and M, 66 and 64, respectively, married filing jointly project that they will receive approximately $70,000 in gross income for 1997 and will have approximately $15,000 in itemized deductions and personal exemptions.

Projected gross income:
M's SE earnings $8,640(1)
Investment income 37,360
Social Security benefits 24,000
Total income $70,000

(1) Maximum allowable earnings for an individual under age 65 without a reduction in benefits.

M is considering increasing her SE earnings by $1,000; this will results in a negative cash flow.

Computatin of net cash flow for $1,000 incremental SE earnings:
Gross SE income $1,000
Reduction in Social Security benefits (500)(1)
Additional Federal income taxes (439)
Additional SE taxes (141)(2)
Net cash flow $ (80)
Effective marginal tax rate 108%

(1) For individuals under age 65, benefits are reduced by $1 for every $2 or earnings in excess of the allowable limit.

(2) SE trax: $1,000 x 0.9235 x 0.153 = $141.

Computation of income tax:
 Without With
 additional additional
 $1,000 $1,000
 SE income SE income

SE income $ 8,640 $ 9,640
Investment income 37,360 37,360
Includible Social
 Security benefits 17,900(1) 18,538(2)
Gross taxable income 63,900 65,538
Less: 1/2 SE tax 610 681
AGI 63,290 64,857
Itemized deductions
 and exemptions 15,000 15,000
Taxable income $48,290 $49,857

Income Tax $8,165 $ 8,604

Additional tax $ 439

(1) Provisional income: $8,640 + $37,360 + (0.5 x $24,000) = $58,000 Taxable benefits: $6,000 + (0.85 x ($58,000 - $44,000)) = $17,900 (2) Provisional income: $9,640 + $37,360 + (0.5 x ($24,000 - $500)) - $58,750 Taxable benefits: $6,000 + (0.85 x ($58,750 - $44,000)) = $18,538

If the taxpayer is between ages 65 and 69, has already experienced a full phase-in of Social Security benefits, and were to receive wages instead of SE income, the effects would be less onerous.

Should the Taxpayer Generate More Income?

SSRs considering generating additional income may seek to base the decision on whether the incremental income will be subject to a multiplier effect. For example, a taxpayer may seek to generate income if it would be subject to a 28% rate, but not an effective 51.8% tax rate.

Determining a client's effective marginal tax rate(s) may create a quandary for the practitioner. While a taxpayer's decision to generate additional income or expenses (e.g., purchase of Sec. 179 business equipment) should include consideration of the effective tax rate(s), the cost of making that determination through multiple projections may not be cost-effective, especially when the amount of incremental income is relatively small. Graphic analysis, however, may provide a relatively efficient alternative to the preparation of projections.

Graph 1, above, and Graph 2, at right, provide approximate evaluations of the effects of changes in incremental income. These figures may be used in conjunction with Tables 1 and 2, on pages 570 and 573, respectively, which list in $1,000 increments of Social Security benefits, the points at which there is a full phase-in of such benefits.


Table 1: Phase-in Levels for Includibility of Social Security Benefits--Single Taxpayers
 Provisional income Provisional income
 $25,000-$34,000 $34,000 +:
Total Provisional income Provisional income
Social for phase-in of for phase-in of
Security benefits subject to benefits subject to
benefits 1.5 multiplier effect 1.85 multiplier effect

$1,000 $26,000 $34,412
 2,000 27,000 34,824
 3,000 28,000 35,235
 4,000 29,000 35,647
 5,000 30,000 36,059
 6,000 31,000 36,471
 7,000 32,000 36,882
 8,000 33,000 37,294
 9,000 34,000 37,706
10,000 34,000 38,706
11,000 34,000 39,706
12,000 34,000 40,706
13,000 34,000 41,706
14,000 34,000 42,706
15,000 34,000 43,706

Table 2: Phase-in Levels for Includibility of Social Security Benefits--Married Taxpayers Filing Joint
 Provisional income Provisional income
 $32,000-$44,000 $44,000 +:
Total Provisional income Provisional income
Social for phase-in of for phase-in of
Security benefits subject to benefits subject to
benefits 1.5 multiplier effect 1.85 multiplier effect

$1,000 $33,000 $44,412
 2,000 34,000 44,824
 3,000 35,000 45,235
 4,000 36,000 45,647
 5,000 37,000 46,059
 6,000 38,000 46,471
 7,000 39,000 46,882
 8,000 40,000 47,294
 9,000 41,000 47,706
10,000 42,000 48,118
11,000 43,000 48,529
12,000 44,000 48,941
13,000 44,000 49,941
14,000 44,000 50,941
15,000 44,000 51,941
16,000 44,000 52,941
17,000 44,000 53,941
18,000 44,000 54,941
19,000 44,000 55,941
20,000 44,000 56,941
21,000 44,000 57,941
22,000 44,000 58,941
23,000 44,000 59,941
24,000 44,000 60,941
25,000 44,000 61,941
26,000 44,000 62,941
27,000 44,000 63,941
28,000 44,000 64,941
29,000 44,000 65,941
30,000 44,000 66,941

Example 3: D, a single taxpayer, projects that her 1997 provisional income will be $27,000, which includes one-half of her $6,000 total Social Security benefits. D has the opportunity to increase her income through consulting work and/or other means (e.g., individual retirement account (IRA) withdrawal).

The use of a graph allows for a quick evaluation of the effects of generating various levels of additional income. On Graph 1, the starting point is the point at which provisional income is $27,000 (per the bottom set of figures) and Social Security benefits are $6,000 (per the figures on the left side). D currently must recognize $3,000 (($27,000 - $25,000) x 1.5 multiplier effect) in taxable income for the $2,000 of provisional income exceeding the $25,000 threshold.

* Graph 1, Area A: At the $6,000 level of annual Social Security benefits, any increase beyond $27,000 in provisional income, up to a total of $31,000 in provisional income, is subject to a 1.5 multiplier effect. Thus, if D generates an additional $4,000 in income, she will be required to include an additional $2,000 of Social Security benefits, for a total $6,000 increase in taxable income ($4,000 x 1.5 multiplier effect). If D's marginal Federal tax rate is 15%, her effective marginal tax rate for the $4,000 of income would be 22.5% (15% x 1.5); her marginal tax would be $900 ($4,000 x 1.5 x 15%).

* Graph 1, Area B: The next $3,000 (i.e., incremental income between $4,000 and $7,000), which represents provisional income between $31,000 and $34,000, is included at face value. There is no multiplier effect and no deterrent from a Social Security perspective toward generating additional income. No additional Social Security benefits are taxable, because their full amount has been included at the 50% level and provisional income is below the threshold for inclusion of benefits at the 85% level.

* Graph 1, Area C: The next $2,471 (i.e., incremental income between $7,000 and $9,471), which represents provisional income between $34,000 and $36,471, is subject to a 1.85 multiplier effect (i.e., $2,471 in earnings generates $4,571 in gross income). The additional $2,471 represents the full phase-in of Social Security benefits at the 85% level. Table 1 indicates that $36,471 is the phase-in point for $6,000 in Social Security benefits.

If D's marginal Federal tax rate was 28%, her effective marginal tax for this range of income would be 51.8% (28% x 1.85);27.75% at a 15% marginal rate (15% x 1.85).

* Graph 1,Area D: Any income beyond the $9,471 incremental total is not subject to a multiplier effect, because there is already an 85% phase-in of D's Social Security benefits.

A taxpayer has a variety of incentive levels, based on effective marginal income tax rates, towards generating incremental income, as shown below.
Incremental Increase Marginal Effective
income Multiplier in taxable income marginal
generated effect income tax rate tax rate

$ 4,000 1.5 $ 6,000 15% 22.5%
 3,000 0 3,000 28% 28%
 2,471 1.85 4,571 28% 51.8%
 4,029 0 4,029 28% 28%
$13,500 $17,600

If D is between 65 and 69, she would be subject to a $1 loss in benefits for every $3 of earned income in excess of $13,500. However, D can generate an unlimited amount of unearned income without being subject to a reduction in benefits.

A potentially significant consideration is the dilution of the impact of the multiplier effect as income increases beyond the full phase-in level for Social Security benefits. In Example 3, the multiplier effect applicable to income generated between $7,000 and $9,471 would seem likely to be a strong factor in determining whether to generate $10,000 in additional income. The multiplier effect, however, would seem to be a less important factor in deciding whether to generate $30,000 of unearned income, because a much smaller portion of income would be subject to its impact.

Although the dollar amounts discussed here are relatively modest, the multiplier effect may be critical in deciding whether to engage in consulting work, especially when the taxpayer is also subject to SE(4) and/or state and local taxes.

The decision whether to generate income may also be important for year-end tax decisions, such as whether to withdraw funds from an IRA or sell a capital asset at a gain. For example, a taxpayer may be inclined to sell an asset at a gain if it would be subject to a marginal tax rate of 28%, but not 51.8%.

Example 4: B and C, married filing jointly, project that for each of 1997 and 1998, provisional income will be approximately $50,000, which includes one-half of their $20,000 in total Social Security benefits. B and C are considering withdrawing a total of $15,000 from their IRA accounts over the two years to provide themselves with additional cash.

The starting point for this evaluation is Graph 2, at the point at which provisional income is $50,000 and Social Security benefits are $20,000. Table 2 may be used to identify the point at which there is a full phase-in of Social Security benefits.

* Graph 2, Area C: Additional income generated up to total provisional income of $56,941 is subject to a 1.85 multiplier effect. Thus, the first $6,941 in IRA funds withdrawn yearly causes the inclusion of an additional $5,900 in Social Security benefits.

* Graph 2, Area D: When provisional income exceeds $56,941, there is a full phase-in of Social Security benefits. Incremental income would not be subject to the multiplier effect.

Planning note: In 1997, B and C could withdraw the $15,000 required for the two-year period. They would then be subject to the multiplier effect for only $6,941 in income, rather than for double that, which would occur if the income was withdrawn in roughly equal amounts over two years.

Planning Opportunities

A number of planning mechanisms are available for taxpayers to minimize the includibility of Social Security benefits. Several of these techniques (especially those relating to the use of stock index funds and annuities) can provide benefits to many taxpayers who may previously have believed their income was too high to benefit from planning in this area. Decisions to employ any or all of the techniques examined here may require comprehensive consideration of a taxpayer's financial goals and attitude towards risk. Tax practitioners may need to remind their clients, before implementing planning strategies, that tax ramifications should not be the most important factor in making investment decisions.

Stock Index Funds

Stock index funds provide excellent opportunities for income deferral because of their extremely low asset turnover rate.(5) The low level of asset turnover generally results in minimal capital gains distributions. Additionally, the range of specialized indexes (e.g., Morgan Stanley Capital International for international investing) makes index-based investing viable for older taxpayers with a wide array of investment objectives.

Example 5: Husband and wife, P and Q, ages 66 and 65, are considering shifting a portion of their portfolio's assets into stock index mutual funds. Projected 1997 gross income amounts are shown for the current portfolio and for a revised portfolio that contains stock index mutual funds.

Projected gross income--current portfolio (no stock index funds)
$300,000 in mutual funds
 (15% average yield, fully taxable) $45,000
$300,000 fixed Treasury investments
 (6% averagte yield, fully taxable) 18,000
Social Security benefits
 ($27,000 gross, 85% taxable) 22,950 22,950
Gross income $85,950

Projected gross income--revised portfolio
(contains stock index funds)

$300,000 in stock index funds
 (15% average, 3% average taxable
 yield(1)) $9,000
$300,000 fixed Treasury investments
 (6% average yields, fully taxable) 18,000
Social Security benefits
 ($27,000 gross) 4,250(2) 4,250
Gross income $31,250

Reduction in includible Social Security
benefits $18,700

(1) The assumptionj of a 3% tax rate for an index fund yielding 15% is based in the 1996 performance for the Vanguard Index 500 Fund, the nation's largest index fund. At Dec. 31, 1996, that fund had an annual return of 22.9% and a closing price of $70.16 /share. Income dividends and capital gain dividends through Dec. 27, 1996 were $1.28 and $0.25, respectively (per Barron's, 12/30/96, p. MW 79). Investors potentially may achieve even greater income deferrals through growth-oriented index funds that emphasize capital appreciation.

(2) Computation of includible Social Security benefits: Provisional income: $9,000 + $18,000 + ($27,000 x 0.50) = $40,500 Includible Social Security benefits: ($40,500 - $32,000) x 0.50 = $4,250

The reduction in Social Security benefit taxability is in addition to the $36,000 reduction in taxable mutual fund income ($45,000 - $9,000) that would apply to all taxpayers. Of particular interest to older taxpayers, index funds allow an estate to receive a tax-free step-up in basis for unrecognized capital gains, but the estate could not deduct unrecognized losses. Further, the funding of the stock index investment may require a disposition of appreciated assets (e.g., fully taxable mutual fund shares that have appreciated in value) that may trigger the recognition of taxable income.

A nontax consideration is that current cash low is reduced. Shareholders of stock index funds can achieve a tax deferral only if they continue to hold (rather than dispose of) shares containing unrecognized gains. If, in Example 5, P and Q were relying on the $45,000 of mutual fund income for current cash needs, the use of stock index funds would not be an effective planning technique to the extent that appreciated shares were converted into cash.

Apportioning Assets Between Tax-Deferred and Nondeferred Accounts

Taxpayers who can select specific assets for their retirement accounts may potentially be able to reduce current taxes by allocating investments with higher taxable yields to tax-deferred accounts (e.g, IRAs) and allocating investments with lower taxable yields to nondeferred accounts. Because stock index funds typically generate taxable income of 3% or less, they may be appropriate for the nondeferred portion of an investor's portfolio. Allocation to tax-deferred accounts of investments that are expected to have higher current taxable yields (e.g., fixed investments and actively managed mutual funds) may allow for greater deferral of current taxable income. A potential detriment, similar to Example 5, is that effective implementation of the strategy requires limits on current cash withdrawals.


While all taxpayers can defer income recognition through the use of annuities, SSRs may find this mechanism particularly attractive when its use allows for leveraging (i.e., reducing the multiplier effect for inclusion of Social Security benefits). In the early years of an annuity, amounts that are, in effect, interest income are characterized as returns of principal.

Example 6: T invested $500,000 in a 6% certificate of deposit (CD) and also in a 10-year, 6% annuity. The annuity's annual combined payout of interest and principal is $67,935.(6) At the end of the first year, the CD generates $30,000 in taxable interest; the first year's taxable income for the annuity is $17,935. The remaining $50,000 of first-year proceeds would be a return of principal(7); thus, T achieves a first-year deferral of $12,065 of taxable income.

Annuities may be a particularly attractive non/ex-deferred investment choice for taxpayers who are also holding stock index funds. Because in their early years, annuities normally generate cash well in excess of both their effective and taxable income, they may at least partially offset the reduction in cash a taxpayer might experience after converting other investments into a stock index fund.

Planning for the use of annuities must also consider the effects in later years when the investment will yield taxable interest income in excess of current effective earnings.

Other Investment Strategies

Use U.S. Savings Bonds to defer investment income: Although the rate of return is relatively modest, these investments may be attractive for the conservative portion of an investor's portfolio, in cases in which income would otherwise be expected to be subject to the multiplier effect. However, U.S. Savings Bonds proceeds used for educational expenses are indudible in provisional income under Sec. 86(b)(2).

Invest in a diversified portfolio and recognize gains/Losses at year-end: A taxpayer holding unrealized capital loss assets may, when the multiplier effect applies, make a sale prior to year-end and reap as much as a 1.85:1 benefit (e.g., a $3,000 capital loss could result in a $5,550 reduction in taxable income). Similarly, a taxpayer may choose to sell unrealized capital gain assets when there is already a full phase-in of Social Security benefits.

Select investments with zero (or minimal) distributions of current income: Investments in growth stocks and precious metals may allow for a deferral until the taxpayer's provisional income is lower. Because these types of assets are generally subject to higher volatility, their appropriateness may vary depending on the individual's attitude towards investment risk.

Invest in active participation rental real estate and/or plan for a tax-advantaged retirement home: The most basic advantage of active participation rental real estate is that it allows taxpayers (subject to certain income limits) to deduct currently losses generated by the property under Sec. 469(i), a benefit that can be leveraged for SSRs who are subject to the multiplier effect. Additionally, the property may be converted to personal use without depreciation recapture.(8)

Example 7: S, age 65, buys a condominium in 1997. During the first five years of ownership, while S is semi-retired, he rents out the property. If S is in the 28% tax bracket and 85% of his Social Security benefits are includible, his taxes may be reduced by as much as 51.8% of the properly 's taxable losses. In 2002, when S is fully retired, he converts the property into a personal residence Although the use of the property has changed, S is not required to recapture depreciation.

Other Reduction Techniques

Maximize contributions to retirement accounts: Under Sec. 219(d)(1), a qualifying individual may make deductible IRA contributions, even while receiving Social Security benefits, until the tax year he attains age 70 1/2. Qualifying individuals can continue to contribute to Keoghs and simplified employee pensions even after attaining that age.

Time distributions from retirement accounts to correspond with the full phase-in of benefits: As discussed in Example 4, an SSR already reporting 85% of his benefits potentially may avoid application of the multiplier effect by taking a distribution of the following years' planned retirement account disbursements.

Maximize Sec. 179 expense deductions: When a SE taxpayer is considering purchasing business equipment, the Sec. 179 expense election may allow him to obtain a benefit up to 185% of the asset's purchase price. This technique, which is also available to active partners and S corporation shareholders, can be quite useful for year-end tax planning.

Example 8: On Dec. 20,1997, T, age 68, a semi-retired consultant, has estimated 1997 provisional income of $40,000 that includes one-half of his $12,000 in total Social Security benefits. T is considering buying a $5,000 piece of business equipment. If T purchases the equipment before year-end and qualifies to elect Sec. 179, he could potentially reduce his taxable income by $9,250 ($5,000 x 1.85). T may also benefit from reductions in his SE and state income taxes. Additionally, if T's SE earnings before the equipment purchase were greater than $13,500, he could benefit by avoiding the $1 for $3 reduction in his Social Security benefits.

Initial Receipt of Benefits

Defer collection of first-year benefits into the following year, if provisional and/for taxable income is expected to decline: Many taxpayers who work during at least part of their retirement year may have high provisional income. If these taxpayers begin collecting Social Security benefits that year, it is likely that 85% of the benefits will be includible. This can be avoided by delaying filing of the initial application for benefits until near year-end. Individuals may delay filing the initial application for up to six months without losing benefits.

Example 9: B plans on retiring when she turns 65 in duly 1998. B's income for 1998, including pre-retirement wages and excluding Social Security benefits, will be approximately $40,000. B is eligible to receive approximately $5,000 in Social Security benefits in 1998. Because B's 1998 provisional income is high and her Social Security benefits are low, she would have to include 85% of the benefits received in 1998 income. However, if B waits until late 1998 to apply for benefits, they will not be received until the following year. B could potentially benefit in 1999 in two ways: inclusion of lesser benefits, subject to a lower tax rate.

Elect, when beneficial, to include a receipt of retroactive benefits in accordance with the prior-year's requirements for inclusion: Under Sec. 86(e)(1), a taxpayer who receives benefits attributable to a prior year may elect to include them in provisional income as if they have been received in the applicable year.(9) Receipt of retroactive benefits could occur, for example, when a taxpayer receives a distribution of benefits following the resolution of a dispute with the SSA.

Example 10: H receives $10,000 in Social Security benefits in 1997, $4,000 of which are attributable to 1996. H's 1997 provisional income is such that 85% of his benefits would be includible; his 1996 provisional income was such that only 50% of such benefits would be includible. In the absence of an election, H would have to include $8,,500 in benefits in 1997 income; with the electron, H can include only 57,100 $4,000 x 0.5) + ($6,000 x 0.85)) of benefits in income.

The election may be used for any receipt of retroactive benefits, not only initial benefits, and may be particularly valuable when income is received attributable to pre-1994 tax years, because the maximum inclusion for those years was 50%.

Defer becoming an SSR: Taxpayers whose earned income levels exceed the annual limit (e.g., $13,500 in 1997), who would be subject to a reduction in the payment of benefits, may elect to postpone their initial participation. Individuals who elect in 1997 to postpone participation receive a 5/12 of 1% increase in benefits for each month of forgone participation (i.e., 5% annually). This option is available until an individual attains age 70.(10) While the annual increase is small, the option may be worthwhile when high current earnings would cause a taxpayer to forgo or return a substantial portion of his benefits.


Taxpayers and their advisers may want to consider a wide range of techniques to minimize taxation of Social Security benefits. The specific mechanisms chosen will vary with the taxpayer's income objectives and attitude towards investment risk. Planning strategies for taxpayers ages 65 through 69 should also take into account the increased annual earnings limit.

(1) 42 USC Section 403(f)(8)(D).

(2) Annual increases in allowable earnings for SSRs under age 65 continue to be linked to increases in monthly Social Security benefits.

(3) "Provisional income" is not defined in the Code of regulations, but is referred to in H. Rep. No. 103-111, 103d Cong., 1st Sess. 654 (1993), 1993-3 CB 230.

(4) A factor potentially diminishing the disincentive towards generating SE income is the set of scheduled increases in the allowance for deducting health insurance premiums. The allowance is 40% in 1997. gradually rising to 80% in 2006, under Sec. 162(1)(1).

(5) For example, the Vanguard Index 500 Fund's asset turnover rate for 1996 was approximately 4%, compared to a 97% turnover level for all mutual funds, see "Paying for Admission is No Guarantee of Seeing a Better Performance," The New York Times (9/15/96), Section 3, p. 5.

(6) present value of $1 received annually for 10 periods, discounted at 6% = 7.36; present value: $500,000 - 7.36 = $67,935 annual cash flow.

(7) Under Regs. Sec. 1.72-4(a)(1)(i), the exclusion ratio is determined by dividing the investment in the contract by the total expected return. Taxpayers experience a deferral because the excluded amount of a distribution is determined under a straight-line, rather than on an economic, basis (which would require the exclusion to be adjusted annually to reflect compound interest effects).

(8) See Rev Rul. 69-487, 1969-2 CB 168.

(9) According to Sec. 86(e)(2)(A), a benefit is attributable to a tax year if its generally applicable payment date occurred during that year.

(10) This delayed retirement credit increases to 5.5% annually for 1998 1999 and ultimately increases to an 8% annual rate in 2008, under SSA Section 202(w)(6) (42 USC Section 402(w)(6)) and SSA Regs. Section 404.313(b)(4).


* Poor (or no) planning can result in double jeopardy: a reduction in benefits for exceeding the annual earnings limit and inclusion of 85% of benefits received.

* An SSR who receives benefits attributable to a prior year may elect to have them taxed as if received in the year to which attributable.

* A major planning technique is to defer the receipt of non-Social Security income, to keep provisional income low enough to avoid inclusion of Social Security benefits.
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Author:Hammer, Seth
Publication:The Tax Adviser
Date:Sep 1, 1997
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