TAXING SOCIAL SECURITY

Many retirees are surprised to learn that Social Security benefits may be subject to federal income tax depending on overall income. Understanding how benefits are taxed—and when they are not—can help retirees better plan for their cash flow and avoid unexpected tax consequences.

The taxation of Social Security benefits seems a bit odd to me. The federal government imposes a tax on your earnings, so during your working years you and your employer pay a tax to the federal government that will eventually form your Social Security benefit. Then, when you retire, the federal government pays a benefit to you – and perhaps, members of your family – that is derived from those contributions. Yet, in certain instances, the government asks for some of those benefits back in the form of tax.

You might not pay any tax, or you might pay tax as high as 85% of your benefits. But whether or not you will pay any tax on your benefits depends not only on the dollar amount of your benefits but on the amount and source of your other income.

There is a two-tier system for determining the amount of tax, if any, that you will pay on your Social Security benefits. The formula of income on which this two-tier system calculates the tax owed is based upon the taxpayers Adjusted Gross Income, plus tax-free interest income, plus one-half of the taxpayer’s Social Security benefit. The result of this income formula is often referred to as “provisional income.”

You might notice that tax-free income is included in the calculation of provisional income. This does not mean that tax-free interest income – most often derived from municipal bonds – suddenly becomes taxable. What it means is, the tax-free interest income is factored into the formula for calculating provisional income, which determines the amount of your Social Security benefit that will be subject to tax. In this sense, tax-free interest income in retirement can actually increase your overall tax liability, notwithstanding the fact that the tax-free interest income is tax-free.

Once provisional income is calculated, the result is compared to income thresholds of $25,000 for a single person and $32,000 for a married couple. These thresholds are not adjusted for inflation, so as time passes, more-and-more people will be subject to the taxation of their Social Security benefits, as COLAs increase their overall income. The excess of provisional income over the applicable threshold is computed and one-half of that result is treated as taxable income.

For example, assume that Mary has pension, dividend, and corporate bond interest of $18,000, as well as tax-free interest income of $4,000 and Social Security benefits of $11,000. Mary’s provisional income is $18,000, plus $4,000, plus $5,500 (or one-half of her Social Security benefit), or $27,500.

Mary’s income exceeds her threshold by $2,500 ($27,500 – $25,000 = $2,500). Of that amount, one-half – or $1,250 – is taxable. The remainder of Mary’s Social Security benefits – or $9,750 ($11,000 – $1,250 = $9,750) – is tax-free.

In typical fashion, to increase the tax that higher income individuals pay, the feds impose a second-tier of taxation for those individuals who have higher provisional income. The second tier thresholds are $34,000 for a single person and $44,000 for a married couple. 85% of the excess of provisional income over these thresholds is added to the first tier excess to calculate the income subject to tax.

For instance, assume that Mary had pension, dividend, and corporate bond interest income of $25,000, as well as tax-free interest income of $6,000 and Social Security benefits of $11,000. Mary’s provisional income is now $36,500 ($25,000 + $6,000 + $5,500, or one-half of the Social Security benefit = $36,500). Accordingly, the taxable income is computed as follows: First Tier Calculation: $34,000 – $25,000 = $9,000 * 50% = $4,500 (but never more than one-half of Mary’s benefit, which is $5,500); Second Tier Calculation: $36,500 – $34,000 = $2,500 * 85% = $2,125; bring the total taxable portion of Mary’s income to $6,625 ($4,500 + $2,125 = $6,625).

Because tax rules can change and individual income situations vary, reviewing how Social Security benefits fit into your overall financial picture is an important part of retirement planning.