A common question around FERS retirement is when to start taking Social Security. This is a dynamic question that varies from person to person and family to family.

There are multiple reasons to delay Social Security, but one I don’t hear very often involves effective tax. The term effective tax applies to the amount of tax that would be paid on additional income.

The most common place effective tax comes into play for retirees is on additional income when they collect Social Security (SS). A retiree may look at tax planning and think that the only taxes they should worry about are federal and state income tax, which is partially accurate; additional income, however, can cause a larger percentage of their Social Security to be taxed.

Social Security is taxed based on the amount of your combined income. Combined income is defined as:

adjusted gross income (AGI) + nontaxable interest + ½ of your Social Security benefits.

Here is how Social Security is taxed for individuals if combined income is:

• between $25,000 and $34,000 you may have to pay income tax on up to 50% of your benefits.
• more than $34,000, up to 85% of your benefits may be taxable.

For Married Filing Joint (MFJ) if combined income is:

• between $32,000 and $44,000, you may have to pay income tax on up to 50% of your benefits.
• more than $44,000, up to 85% of your benefits.

As you can see, it doesn’t take a very high income to cause up to 85% of your benefits to be taxable. But the rules also don’t specifically say that income above $44,000 will automatically cause 85% of your benefits to be taxed; the rules state that up to 85% may be taxed.

Retirees that collect Social Security at the age of 62, or even prior to 70 years old, may find themselves paying an effective tax of 22.2% on TSP distributions.

Let’s check out Joe and Mary Federal’s retirement income for an example.

Joe’s FERS = $25,000

Mary’s FERS = $20,200

Joe’s Social Security at 62 = $24,000

Mary’s Social Security at 62 = $21,000

If Joe and Mary choose not to collect SS benefits at 62, they will pay income taxes on Thrift Savings Plan (TSP) distributions at a rate of 12%. Their taxable income will be:

$25,000 + $20,200 – the standard deduction of $27,700 = $17,700.

The top of the 12% tax bracket is $89,450, which means they can take distributions up to $71,750 and only pay 12% in federal income tax.

But what would happen if they started collecting SS at age 62?

Collecting Social Security at age 62 would move their taxable income up to $43,645 because only 58% of their SS would be taxed. You may think they would pay 12% on distributions from TSP since they are still in the 12% tax bracket, but that’s where effective tax comes in.

While it’s true that they would pay income tax of 12% on TSP distributions, any additional income would cause more of their Social Security to be taxed. Instead of paying 12% on additional income, they would pay a 22.2% effective tax on the next $14,000 of income, which is 10.2% higher than most people would expect. Then they would pay a marginally higher effective tax on the next $2,000 of income before returning to the 12% rate on any additional income.

What does this mean for retirees?

The tax code can be complicated, and retirees may believe they are paying one rate on additional income but could possibly end up paying significantly more. This could lead to a tax bill when they file their taxes if they don’t have enough income tax withheld.

Effective tax is rarely considered when retirees are making a Social Security claiming decision, but it should be part of the decision. For retirees who may be on the fence and trying to decide when to take Social Security, the effective tax could be the deciding factor in their decision. Retirees who want to convert funds to a Roth IRA early in retirement may benefit by delaying Social Security.

If you are a retiree or soon-to-be retiree and would like help navigating the distribution phase, please schedule an introductory meeting with me.

Brad Bobb, CFP® is the owner of Bobb Financial Inc, and an expert in retirement planning for federal employees.