The majority of the rules and funding policy that controls how Social Security works today were put in place by the congressional Greenspan Bipartisan Commission’s overhaul of the system in 1983. Prior to 1983, Social Security payments were not counted as income; as a result, no income tax was due on these payments. However, one of the ways the Greenspan Commission found that would help keep the system more solvent over a long period of time was to introduce the idea that some of the Social Security income should be reported as income and taxed.

The IRS was charged with the task of determining how Social Security should be taxed. In 1984, it started the process of counting Social Security payments as income. Today, the IRS publication 915 is the go-to document that explains the exact details of how Social Security is handled as taxed income.  2022 Publication 915 (irs.gov)

At the core of this tax question is the definition of “Combined Income.”  Combined Income, as defined in the 915 IRS publication, is the key calculation that determines how much of the Social Security benefit is reported as income. For Social Security purposes, the definition of Combined Income is: one half of your total Social Security payment (which could include any lump sum payments for the year), plus all of your adjusted gross income other than Social Security, plus any nontaxable interest income (e.g., interest on a municipal bond).

The result of this logic creates the “Combined Income” calculation. Combined Income is then subject to a filing status bracket test as shown in this chart. See this link to SSA.GOV Benefits Planner | Income Taxes and Your Social Security Benefit | SSA

Here is the problem. Other Social Security qualification tests, such as the earning wage base, the amount of income needed to earn a Social Security working credit and the full retirement age earnings test thresholds, are being indexed for cost-of-living increases each year. This is logical and keeps the system in sync with economic trends over time. However, the Combined Income threshold numbers that determine the amount of tax on Social Security payments are not being indexed. It is this non-indexing that creates the “stealth tax.” As income gradually increases, the amount of income tax on Social Security may also increase because the bracket amounts for the Combined Income test are not moving year over year.

Many retirees find that there is very little they can do to avoid the stealth tax without careful preplanning. Social Security automatic cost-of-living adjustment (COLA) increases can, and will, increase income. The COLA increase to Social Security benefits was 5.9% in 2022 and 8.7% in 2023. The announced increase for the COLA adjustment in 2024 is 3.2%. Over a three-year period, a 17.8% increase in Social Security benefits could automatically result in more income tax on Social Security benefits.

In addition to COLA increases, required minimum distributions (RMD) on qualified accounts can force retirees into higher tax brackets and higher Combined Income test limits. These RMD requirements can have a dramatic impact on taxable income; the higher the qualified account balance, the higher the RMD.  It is a circular issue that often forces the exposure to the higher Combined Income tax brackets and, as a result, produces higher income tax on Social Security benefits.

When a partner dies, the brackets shift down dramatically and could increase the tax on Social Security benefits. Notice in the chart that the single filer is exposed to the higher tax with just $34,000 in Combined Income; this compares to the $44,000 bracket for a married couple. Because of this bracket shift, a single taxpayer could very well be paying more income tax on their benefits than when both partners were alive.  

How do retirees manage the stealth tax? Here are three ways:

1. The ROTH conversion is one strategy that could help. It would be best to pay income tax due on a ROTH conversion with funds outside of the qualified plan. (However, the conversion could also be funded with funds inside of the qualified plan.) Either way, moving traditional tax qualified money into a ROTH that has no RMDs attached could reduce taxable income in the future and potentially keep the Combined Income tax brackets under control.
   
   
2. Controlling distributions from qualified plans is another way to manage the stealth tax. As an example, starting distributions prior to the mandatory RMD start date could lower the qualified plan balance in the future and possibly lower the RMD. A lower RMD amount lowers the income tax due and could help expose less Social Security payments to income taxes.
   
   
3. Another way to control RMD distributions from a traditional tax qualified account is by the use of a qualified longevity annuity contract (QLAC). The SECURE 2.0 Act of 2022 increased the amount that a worker can put into QLAC to $200,000. The QLAC allows that qualified money to be deferred up to age 85 and then coverts it into an income stream for life; plus, there is flexibility on the start date. Structured like a bond ladder, a worker could have a QLAC ladder that would stagger the start dates of the payments over different periods of time.
   

It is well known that when a retiree takes one dollar from a qualified plan, it is reported as income at 100%. What some retirees forget is when they receive one Social Security dollar, it will always have at least a 15% tax advantage over the traditional qualified plan dollar distribution.

Qualified dollars are tax-tainted when distributed. Social Security dollars are tax-favored when distributed. In addition, in most states, Social Security dollars are either not subject to state income tax or receive favorable tax treatment.

Perhaps the best way lower or avoid the “stealth tax” is to be aware of how Combined Income is calculated and apply some long-range tax planning to be sure the income is not exposed to higher tax brackets.

There is no one right approach when it comes to mitigating the stealth tax. Rather, it takes thought and planning with a combination of approaches to maximize spendable income in retirement.

David Freitag, CLU, ChFC, CRPC, is a financial planning consultant at MassMutual.