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.
Bottom Line
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?
Ronald R. Dodge, Jr. says
July 18, 2012 at 12:18 PMFor me, I lived on SSA benefits and it’s not fun. As for how much SSA benefits I will get in retirement years, the only part I can control of that is when do I retire. Not only that, but notice how the $25,000/$34,000 provisional income limits has been static. (IRS terms in the tax code, which is really MAGI with only minor differences) As such, by the time I enter into retirement, I’m already counting on 85% of my SSA benefits to be taxable as will at least 90% of the households with SSA benefits unless Congress changes that rule before then. The provisional income limit does not take into account of inflation, which back in 1990, a single person could live on $25,000, but today, forget it.
JoeTaxpayer says
July 17, 2012 at 9:23 PMA single person with $34K taxable income expects to be just entering the 25% bracket (at $35,350 in 2012 to be precise), but the effect of the 85% social security becoming taxable means that after hitting the 25% bracket, the next $1000 of income will increase one’s tax burden by $462.50 (1.85 * 25% = 46.25%). So, combining the advice of delaying social security, meanwhile converting to Roth is an excellent idea. Also, if the RMD puts you into the taxable zone for social security, once at a level when it’s all taxed, a conversion at your regular rate may be in order. That phantom 46.25% only lasts until the social security for the year is fully taxed, then back to 25%.
Ronald R. Dodge, Jr. says
July 18, 2012 at 12:13 PMJoeTaxpayer, your calculation is off:
If your tax bracket is 25% *AND* 85% of your SSA benefits ends up being taxable, then that means for every $1,000 of SSA benefits while in the 25% tax bracket will have a federal tax of $213.00. This does not take into account of the state side of taxation. In some states, it may be more like a tax payment of about $43.00. Even with that, it still only $256.00, not close to the $462.50 you estimated out of the $1,000 going to taxes. For that matter, at least for the state of Ohio, I have estimated maximum taxes for federal and state combined to be 43.1%, which that would come to $366.00 max for every $1,000 of SSA benefits. I know Frank Neal said SSI, but SSI is a different income from SSA benefits, which only applies to people whose SSA benefits and income combined are insufficient (Or should I say VERY insufficient).
JoeTaxpayer says
July 18, 2012 at 1:29 PMRon – Perhaps I wasn’t clear. The next $1000 in SS is taxed at $212.50, I agree. What I referenced was something a bit more insidious. You are in the 25% bracket, and just in the 85% sweet spot for SS. Now, you take out (or convert) another $1000 from your IRA. The net jump in tax is $462.50. It’s a simple calculation and if you grab a recent tax program, you can see it happen.
Once you are are drawing social security, in math terms, it’s a fixed number. But, your IRA withdrawals/conversion are the variable. I discovered this when doing the math to help someone decide how much to convert to Roth, and found the next $1000 producing that crazy jump in tax. Please review my remarks from that perspective and see if we don’t agree.