Tax creep from lack of indexation of Social Security benefits included in AGI

Abstract: The tax code does not link the portion of Social Security included in AGI to inflation. This feature of the tax code leads to tax creep for retirees who do not or cannot change their retirement distribution rules. This post measures this tax creep and considers the feasibility of increasing Roth distributions to counter tax creep.

Introduction: I am both teaching myself how to use CHAT GPT and writing a book on the use of CHAT GPT to evaluate financial issues.

The application discussed here involves financial impacts stemming from the increase in the portion of Social Security benefits included in AGI during a period of inflation.

Most retirement income is linked, either formally or informally, to inflation. Social Security benefits are indexed to a COLA and adjust annually. Many retirees distribute funds based on the four percent rule, which selects an initial distribution rate and adjusts distributions annually for inflation.

Most tax parameter including the tax brackets and the standard deduction are linked to inflation.

The portion of Social Security benefits included in AGI is NOT linked to inflation.

Analysis: CHAT GPT was asked to consider the following situation.

· A married couple has $44,000 in Social Security benefits and $50,000 in retirement distributions with $30,000 coming from a conventional retirement account and $20,000 from a Roth account

· The Social Security benefits and the retirement plan distributions are linked to an inflation index that rises at 3.0 percent per year.

· The standard deduction is linked to an inflation index that rises 2.8 percent per year.

· The parameters determining the amount of Social Security benefits included in AGI are NOT indexed in any way to inflation.

CHAT GPT was asked to provide two deliverables.

· The impact on federal income tax obligations from maintaining the same ratio of conventional to Roth retirement plan distributions.

· The amount the taxpayer needed to shift from conventional to Roth to maintain the same level of taxes.

Results:

· The correct tax calculations are $1,020 for the current year and projected amounts of $1,719 for year 5 and $2,578 for year 10.

· The required conventional/Roth split that maintains current consumption and a tax obligation of $1,020 is $30,999/$26,965 (conventional/Roth) at year 5 and $32,128/$35,068 (conventional/Roth) at year 10.

CHAT GPT concluded with this suggestion. If you’d like, I can also show the tax creep curve over 20–30 years if you didn’t adjust the mix — the unindexed Social Security thresholds make the tax bite grow surprisingly fast.

Discussion: The federal tax bill will rise on average 9.7 percent per year over 10 years for a person maintain a constant conventional to Roth distribution ratio.

A person has to use a lot of Roth funds, instead of conventional funds, to keep taxes at $1,020. The reason why a large increase in Roth funds instead of conventional retirement funds is needed is that conventional retirement are both directly taxed and increase the amount of Social Security benefits included in AGI, while Roth funds are not taxed and do not result in more Social Security being included in AGI.

I am concerned that many retirees must rely on conventional retirement funds because they do not have enough saved in the Roth to avoid large tax increases in retirement.

The recently enacted changes to student loan bill, which allow student borrowers to lower their monthly student debt payment by investing in a conventional retirement account instead of a Roth may exacerbate this problem for future retirees. (See comment 10 in the post on implications of student debt provisions in the tax bill.). Ideally young adults with student debt should contribute to a Roth instead of a conventional retirement account when they are starting their career and their marginal tax rate is relatively low. The new student loan program which links debt payments to AGI could cause some young borrowers with limited cash flow to contribute to a conventional retirement account even though their marginal tax rate is low.

Methodology:

Question: A married couple has $44,000 in Social Security benefits and $50,000 in retirement distributions with $30,000 coming from a conventional retirement account and $20,000 from a Roth account. The Social Security benefits and the retirement plan distributions are linked to an inflation index that rises at 3.0 percent per year. The standard deduction is linked to an inflation index that rises 2.8 percent per year. The parameters determining the amount of Social Security benefits included in AGI are NOT indexed in any way to inflation. How much does the married couple filing a joint return pay in tax this year, in five years, and in ten years? Create a table with this information. Calculate the Roth and conventional distributions, which would lead to an unchanged tax obligation in five years and in ten years? Place result in table. Outline all calculations.

CHAT GPT initially gave a correct answer for Table One and an incorrect answer for Table Two. Initially, table two calculations for the Roth distribution were $50,000 – the conventional distribution. But all retirement plan distributions rise at 3.0 percent per year. I asked for CHAT GPT to correct the mistake. It did not refuse to open the pod bay doors. (A referent to HAL in 2001.)

Authors Note: My book Financial Applications Solved with CHAT GPT will be available in October of this year on Kindle.

I am open reader suggestions for applications in this book.

My economic consulting firm is seeking new clients.

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