It’s an unpleasant fact of life: The taxman can take a bite out of your Social Security benefits.
The federal tax formula was crafted to initially target higher-income households, but the share of benefits taxed has risen over the years, because the income thresholds for taxation aren’t indexed for inflation or real income growth. Meanwhile, there are big variations in how states tax benefits. As a result, a solid retirement plan should include an understanding of whether you will pay taxes on Social Security benefits, how much you’ll pay, and how that will impact your overall tax picture in retirement. In some cases, savvy planning can lessen the tax bite.
About half of all Social Security beneficiaries owed some amount of income tax on their benefits in 2014, according to the Congressional Budget Office (CBO), but the burden falls mainly on higher-income households. Beneficiaries with incomes below $40,000 owed less than 0.5 percent of benefits in taxes in 2014, while those earning more than $100,000 owed 21 percent.
However, the CBO estimates that taxes paid will rise from 6.5 percent of total benefits in 2014 to more than 8 percent by 2024, and more than 9 percent by 2039. That is due to the lack of indexation of the income thresholds.
How benefits are taxed
The formula used to determine the tax is unique. First, you determine a figure Social Security calls “combined income” (also sometimes called “provisional income”). This is equal to your adjusted gross income plus nontaxable interest plus 50 percent of your Social Security.
No taxes are paid by beneficiaries with combined income equal to or below $25,000 for single filers and $32,000 for married filers. (If that sounds like a marriage penalty, that’s because it is one. On the other hand, married couples can access valuable spousal and survivor benefits not available to single people. So, let’s call that one a wash.)
Beneficiaries in the next tier of income—$34,000 for single filers and $44,000 for married filers—pay taxes on up to 50 percent of their benefits. Beneficiaries with income above those levels pay taxes on up to 85 percent of benefits.
Beneficiaries receive IRS Form SSA-1099 from the IRS during tax season, which reports your net benefit subject to tax (after Part B Medicare premiums have been subtracted).
Income is reported on the 1040 or 1040a forms (Form 1040EZ cannot be used). The popular tax-filing software programs also have the capacity to handle Social Security income. You can also ask the Social Security Administration to withhold taxes when you file for benefits at rates of 7 percent, 10 percent, 15 percent or 25 percent. “It’s just a matter of convenience—not a requirement,” says Greg Rosica, a tax partner at Ernst & Young and contributing author to the EY Tax Guide 2016.
State policy on taxation of benefits varies. Twenty-nine states (including the District of Columbia) that have a broad-based income tax exempt all Social Security from tax, according to a tally by the Institute on Taxation and Economic Policy. Seven states tax some Social Security benefits but provide an exemption that is more generous than what is available at the federal level. Six states tax Social Security benefits using the federal formula.
Minimizing the bite
There isn’t much you can do to minimize taxation of Social Security—and most experts don’t consider it important enough to drive overall retirement-plan strategies. “Most of the people we work with understand it—they would prefer not to pay it, but it is what it is,” says Rosica. “Some planning can be done around it, but it can be challenging because planning for this might cause other things not to work as well.”
Still, the taxation of benefits has the effect of boosting marginal tax rates—significantly in some cases. A beneficiary otherwise in a 15 percent tax bracket could face marginal rates of 22.5 percent to 27.75 percent, calculates Michael Kitces, director of research for Maryland-based Pinnacle Advisory Group; those in the 25 percent bracket could see marginal tax rates as high as 46.25 percent. “It just makes your tax bracket higher than you might have otherwise thought,” he says.
The bracket-boosting effect kicks in while Social Security taxes are phasing in—starting at $25,000; after the maximum amount of Social Security (85 percent) has been included in income, the rates start behaving normally again. Managing the timing on drawing income from tax-deferred accounts can help, Kitces says. “When do I take money out? Am I doing a Roth conversion? Do I want to invest in a nonqualified deferred annuity as a way to defer income?”
The Roth calculations, in particular, change when Social Security tax is considered, he says. “The classic rule is to put an available dollar into an IRA when you still are working, if you think your tax bracket will be lower in retirement,” he says. “But if I’m in a 15 percent bracket and it’s actually going to be over 27 percent in retirement, I should pay my tax bill now and fund the Roth.”
An every-other-year strategy for taking tax-deferred income also can help, says Rosica. “If I’m in that $25,000 to $50,000 income level, there probably are ways to arrange your affairs to get better outcomes,” he says.
Kitces adds that, in some cases, the best alternating-year strategy is to add more income in the high-income year, after the 85 percent cap has been hit, to avoid falling in the $25,000 to $50,000 range in the following year.
“This is somewhat counterintuitive for most people, but it’s actually a big opportunity,” he says. “For instance, rather than having annual income of $50,000, you really might be better off by doing $75,000 in one year, then $25,000 the following year. Most people are trained to think that boosting income to $75,000 is ‘higher’ income and causes more taxes when, in reality, it can result in less!”