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Social Insecurity
In future years, we will take IRA distributions to stay under that 46.25% bracket, but once she's forced there again due to rising RMDs, we will implement a Roth conversion plan and convert as much as we can while staying in the 25% bracket. (For 2007, the 25% rate caps at $77,100, this would allow withdrawal of nearly $27K within that bracket) This will give us years of avoiding the higher rate, in perhaps 4 of 5 years.
All situations are different, I have clients who will not come close to the $32,000 where this rate kicks in, and others whose income blows right through it, so it's an unavoidable speed bump they will ride over each year.
It's those who are destined to be right on the edge, where that last $5,000 is taxed at this absurd rate who should start planning on how to avoid it. Forgoing non-matched 401(k) deposits in the final years of work may do the trick. Taking advantage of Roth Iras and Roth conversions may also work. Or any of these ideas combined with a delay in taking Social Security benefits. Best to plan ahead and plan wisely.
Note - you may feel this discussion is 'much ado about nothing', trying to squeeze an extra thousand or so out of the system. Keep in mind, my example here concerns a woman who only receives $15,000 per year in SS benefits. A married couple with one high income earner can have SS benefits totaling over $51,000. In this case there's potential for quite a bit of money to be taxed at their 27.75% phanton rate. A real shame to save pre-tax at 15%, only to pay it back a few years later at 27.75%.
When I first encountered this phantom bracket, I thought to myself, I'm surprised this issue hasn't gotten more press, surely someone had to have written on this topic, I certainly wasn't the first person to fill out a tax return with numbers in this range. After a bit of Googling, I found that Scott Burns addressed this in an article in 2005. No other discussion of this issue that I could discover. A history of Taxation of Social Security Benefits is available on The Social Security Administration site.
While this article was still in preview, open for comments from a few friends, I received a request to produce a similar chart for a couple. While that chart is not quite as dramatic, it still shows the impact of Social Security taxation, and a motivation to plan to avoid that tax.