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How is Social Security Taxed?

 

For some, it’s surprising to learn that social security benefits are taxable.  After all, it’s a system that has taken tax out of your paycheck for so many years, it can be eye opening to learn that the benefits from that system will be taxable yet again. For others, they didn’t realize that only a certain percentage of their social security benefits are taxed based on how much income they have each year.  Whatever camp you are in, it’s important to understand social security benefits and how your overall income picture effects how much of those benefits will add to your taxable income.

 

The Amount Taxed Depends on your Combined Income

Each year, the portion of your Social Security income that’s subject to federal income tax depends on your “combined income.” Your combined income is equal to:

  • Your adjusted gross income (which you can find at the bottom of the first page of your Form 1040), not including any Social Security benefits, plus
  • Any tax-exempt interest you earned, plus
  • 50% of your Social Security benefits.

 

If your combined income is below $25,000 ($32,000 if married filing jointly), none of your Social Security benefits will be taxed.

For every dollar of combined income above that level, $0.50 of benefits will become taxable until 50% of your benefits are taxed or until you reach $34,000 of combined income ($44,000 if married filing jointly).

For every dollar of combined income above $34,000 ($44,000 if married filing jointly), $0.85 of Social Security benefits will become taxable — all the way up to the point at which 85% of your Social Security benefits are taxable. (Note these are general rules, and there can be exceptions to these amounts)

Important note: To say that 85% of your Social Security benefits are taxable does not mean that 85% of your benefits will disappear to taxes. Rather, it means that 85% of your benefits will be included as taxable income when determining your total income tax for the year.

 

How Do Social Security Taxes Impact Retirement Planning?

The big takeaway of the above calculations is that, once you start collecting Social Security, your marginal tax rate (that is, the total tax rate you would pay on each additional dollar of income) often increases dramatically. That’s because, if your “combined income” is in the applicable range, each additional dollar of income is not only taxed at your regular tax rate, it also causes an additional $0.50 or $0.85 of Social Security benefits to be taxable.

This dramatic change in your marginal tax rate often creates significant tax planning opportunities.

For example, if you haven’t yet begun to collect Social Security and you realize that your marginal tax rate will increase once you do, you may benefit from funding most of your current spending via withdrawals from tax-deferred accounts (as opposed to taxable accounts or Roth accounts), thereby allowing the withdrawals to be taxed at your current, relatively-lower tax rate, and thereby preserving your Roth accounts for funding spending needs in the future when your tax rate will be higher.

Or you might even want to take it one step further by converting a portion of your traditional IRA(s) to a Roth IRA in the years of retirement prior to collecting Social Security.

Alternatively, if you are already collecting Social Security, once your combined income nears the range where Social Security benefits will start to become taxable, you may want to fund the rest of your spending (to the extent possible) with assets not from tax-deferred accounts (so as to stay below the range where your benefits would become taxable).

Alternatively, if your combined income is already near the high end of the range in question (such that most or all of your benefits are 85% taxable), it may make sense to withdraw more from your tax-deferred accounts (perhaps just enough to put you up to the top of your current tax bracket) so that you can withdraw less next year, thereby allowing you to stay in the range where your benefits will not be taxable.

In summary, its important to know that your “combined income” does impact how much of your social security benefits are taxable.  If it looks like your marginal tax bracket would increase sharply when you start collecting social security benefits, then it might make sense to fund your spending from tax-deferred accounts before you begin collecting SS.  Once you start collecting on Social Security, then you may be able to reduce your overall tax bill by carefully planning which accounts you do your spending from.