If you are retired or are planning your retirement it’s natural to ask if social security benefits are taxable or not. And if they are taxable, the next question is, what can you do (if anything) to reduce your tax burden?
First let’s understand how social security benefits are taxed. The first thing our friends at the IRS look at is “combined income” which is simply all your income – no matter the source. Half of your Social Security income is included in your “combined income”.
Then add all your other income including tax free interest and income from foreign accounts.
If your combined income is less than $25,000 (singles) or $32,000 (joint filers) your Social Security benefits will be tax free. The schedule below summarizes the tax you’ll have to deal with.
The brackets above are somewhat marginal in that as your income rises (up the maximum) more of your social security benefits are subject to tax. Keep in mind that even if 85% of your social security is subject to tax, that doesn’t mean your tax rate will be 85%. It just means that 85% (in this example) will be subject to your marginal tax bracket.
To actually calculate the amount of social security that will be subject to your marginal tax bracket is complicated. That’s because there are factors, thresholds and other complications that the IRS throws in just to make sure CPA’s have full time jobs.
The Value of Understanding
In most cases, there isn’t a lot you can do about the amount of Social Security that will be subject to tax. But there are a few ways to apply your newly acquired brain power:
a. Consider this Before You Apply for Benefits
If you know that your income is going to drop in a few years, you may want to delay applying for Social Security benefits. This could have the duel effect of increasing benefits once you do start receiving them and reducing the includable amount. This also helps boost Social Security spousal benefits.
b. Convert Your IRA
If you convert your IRA to a Roth you won’t be forced to take any distributions from it and this will keep your “combined income” down (in the year following your conversion).
c. Capital Gains
Offset capital gains with losses in order to reduce your taxable income. While you are probably doing this anyway, it’s good to know that this maneuver could also help you reduce the amount of SSI that you’ll have to include in your AGI.
Tax on Social Security Income benefits is to a large degree beyond your control. Don’t rely on this issue to drive any important financial decision. It’s just something to be aware of. Too often, people make investment decisions based solely on the tax issue and that’s a huge and (potentially) dangerous error. It’s being penny wise and pound foolish.
Make decisions about your income, investments and retirement based on what is most congruent with your overall life goals. The taxation of your Social Security benefits will be impacted but it’s usually a case where the cure (having no income) is far worse than the problem. It’s a far better use of your time to focus on getting the maximum Social Security benefit rather than try to reduce the tax on the money.
Have you made financial decisions based on how your Social Security benefits will be taxed? What did you do? Was it worth it?