It may be frustrating to learn that, after decades of seeing FICA taxes deducted from your paycheck, your Social Security retirement benefits are still subject to income taxes. It sure seems like double taxation, doesn’t it? But is it worth stressing over? Here are three things to know about taxes on Social Security income.
Please note that this week’s blog post only covers the taxation of retirement benefits. Next week, I’ll cover the reduction in Social Security benefits for those who are still working before their Full Retirement Age (FRA).
1. Taxes on Social Security Income are Progressive
Much like income taxes, the tax on Social Security income is also a progressive one. The higher your income, the more you pay. The taxation of Social Security benefits is based upon something the IRS calls “combined income”. We’ll touch on that momentarily.
Only a portion of your Social Security benefits is taxed. For married couples with combined income of less than $32,000, none of their Social Security benefits are included in their taxable income. If a couple’s combined income is between $32,000 and $44,000, half of their Social Security benefits are taxed. Finally, once a couple’s combined income exceeds $44,000, 85% of their Social Security retirement benefits are included in their taxable income.
For single filers, the income limits are different. Social Security benefits aren’t taxed at all for combined income under $25,000. Half of the benefits are taxed if combined income is between $25,000 and $34,000. Finally, 85% of benefits are subject to tax if a single filer’s combined income is over $34,000.
It’s important to point out here that these percentages, 0%, 50%, and 85%, apply to how much of the Social Security benefits are included in taxable income – not the tax rates themselves.
It doesn’t take long to realize that avoiding taxes on Social Security is difficult unless you don’t have any income. These combined income limits were last updated in 1993 and have not adjusted for inflation over the years. Because of this, the overwhelming majority of Social Security benefit recipients end up paying taxes on their benefits.
Depending on how you feel about the government’s stewardship of our tax dollars, it may or may not be of some comfort to know that taxes on Social Security benefits go back into the Social Security trust, rather than be included in general spending.
2. Combined Income Calculation
Even though the limits are relatively low, it is still worth understanding how combined income is calculated. According to the IRS, combined income is calculated as follows:
- Start with your Adjusted Gross Income (AGI),
- Add any non-taxable income, then finally,
- Add ½ of your Social Security income.
Even if you have minimal taxable income in retirement, such as a pension or a distribution from a tax-deferred retirement account, you can find yourself being taxed on 85% of your Social Security income awfully fast.
It’s also interesting to note that non-taxable income, such as interest from municipal bonds, is added back in this calculation. It seems Uncle Sam doesn’t want to give you a double-benefit in that case.
3. Minimizing Taxes on Social Security Should Be a Low-Priority Item
If you’re trying to create a retirement income strategy, minimizing taxes on your Social Security income should be low on the list of priorities. Because the combined income limits are so low in relation to most people’s retirement income needs, it’s difficult to minimize these taxes outside of having a zero-income year.
Remember, at most, only 85% of your Social Security income is taxable. Compared to income from an IRA distribution, which is 100% taxable, it’s clear that other efforts can go further in reducing your overall tax bill. Rather than focusing on minimizing taxes on your Social Security benefits, other tactics, such as making strategic Roth IRA conversions before age 72, could potentially reduce your overall lifetime tax payments.
While it’s important to understand how Social Security income is taxed, there are other considerations that should take priority when planning your retirement income strategy. If you need help designing a plan to minimize taxes and maximize income in retirement, then click here to set up a quick, complimentary introduction call to see if Prana Wealth is a good fit. We do still have the capacity to take on new clients.
As a fee-only financial advisor in Atlanta, we can (and do) work virtually with clients all across the U.S. and we’re here to help you when you’re ready.