We frequently speak with new retirees that are shocked to know that
their Social Security Benefits are taxable. The formulas for determining
your taxable Social Security benefits can be complicated, but with a bit
of effort, you can figure out what your tax liability will be. In some
cases, you can even take steps to reduce the amount of tax you’ll owe on
your benefits.
The IRS lists income limits above which a portion of your Social
Security will be subject to tax. For single recipients, income above
$25,000 subjects as much as 50% of your benefits to taxation, while
income above $34,000 leaves as much as 85% of your benefits subject to
tax. For joint filers, the two analogous threshold amounts are $32,000
and $44,000, respectively. So at first glance, it would seem as if
figuring out your taxable Social Security benefit amount is fairly easy.
However, an initial complication comes when determining income for
purposes of Social Security taxation. You first start by taking your
ordinary taxable income from your tax return. But you also have to make
a couple of additions such as interest from municipal bonds, which is
ordinarily tax-free at the federal level. You also take one-half of your
Social Security benefits and add it to the total in order to come up
with a final income figure.
The language in the IRS description of taxable Social Security benefits
is that “as much as” 50% or 85% of your benefits can be subject to tax.
That doesn’t mean that as soon as you move a single dollar over the
income thresholds that suddenly the full percentage of your benefits
gets included in taxable income. Instead, there is a more incremental
approach to increasing your taxable income.
Let’s assume that you’re single and had Social Security benefits of
$15,000 and other income of $17,500. In that case, half of your Social
Security comes to $7,500, which, when added to your other income, puts
you right at the threshold of $25,000, so none of your benefits are
taxable. But, if you change that example slightly so that your other
income rises by $1,000 to $18,500, your total income for determining
Social Security taxation becomes $26,000, $1,000 above the threshold
amount. Now you will find that your taxable benefits come out to just
$500 — far less than the $7,500 that would represent 50% of what you
got from Social Security.
This example shows that even though up to 50% is subject to tax, the
actual amount is typically 50% of your taxable Social Security income
above the threshold. A similar situation applies to the higher
threshold for 85% inclusion — each dollar of income above the threshold
puts another $0.85 into the taxable Social Security category, but you
won’t see any huge one-time impact simply by hitting that 85% line.
Retirees have a bit of latitude in affecting whether their Social
Security benefits will get taxed. By being smart about selling
investments and taking taxable distributions out of IRAs and 401(k)s,
you can have more or less taxable income that will count against you in
determining taxable Social Security benefits. Taking advantage of
eligible deductions can also help make less of your benefits taxable.
