Thousands of middle-income elderly people with Individual Retirement Accounts or other tax-deferred retirement plans who expected lower tax rates in retirement instead face higher marginal tax rates than younger people -- or even wealthy older people.

The major culprits are the earnings penalty, the so-called Social Security benefits tax and the capital gains tax, says John Goodman, president of the National Center for Policy Analysis. Congress passed reforms in all these areas in its last term, but President Clinton vetoed them all, except for an increase in the earnings penalty threshold.

• The earnings penalty reduces the Social Security benefits of early retirees (ages 62 through 64) who work by $1 for every $2 earned above $8,280 per year (a 50 percent tax rate).

• Added to the income tax, a 64-year-old in the 28 percent tax bracket faces a marginal tax rate of 78 percent.

• Working retirees 65 through 69 are penalized $1 for every $3 earned above $12,500 (a 33 percent tax rate) -- and with income tax face a 61 percent marginal rate.

The marginal tax rate can go still higher due to the so-called Social Security Benefits tax:

• On income beyond $32,000 ($25,000 for an individual), 50 cents of benefits is taxed for each added $1 of income, making their effective tax rate 50 percent higher than it would be otherwise.

• Beyond $44,000 ($34,000 for an individual), 85 cents of benefits is taxed for each $1 of income, making their effective tax rate 85 percent higher.

A recipient subject to both the earnings penalty and the benefits tax can pay more than a dollar in tax on an additional dollar of income, says Goodman. In addition, at least 15 states tax Social Security benefits, and self-employed workers face additional payroll taxes (FICA).

And although the elderly constitute only 12 percent of the population, they hold about 40 percent of all capital assets in the United States. Thus the tax on capital gains hits them harder than any other age group.

Source: John Goodman, "Soaking the Elderly," IntellectualCapital.com, November 14, 1996.