The Double Taxation of Social Security

The concept of paying taxes on Social Security benefits doesn’t sit well with many individuals. After all, the contributions you make in hopes of receiving a future Social Security benefit are after-tax dollars that were involuntarily taken out of your paycheck.

Now the benefit you receive from the system you funded for your working career could be taxed again?!?

I can see why many people feel this puts them on the hook for paying taxes twice on the same dollars. After all, isn’t there something in our complex tax code that stops double taxation? Let’s take a closer look at the issue to get clear on what’s going on.

Is There Double Taxation on Social Security Benefits?

Through the years I’ve read a lot about this issue, but I’ve never seen anything that adequately explained it. Most articles never go deeper than the surface level, which only adds to the confusion.

Most articles I’ve seen try to explain away the double taxation on Social Security benefits issue in a different number of ways. Let me know if any of these sound familiar:

  • It’s not double taxation because the funds you collect don’t come directly from your taxes. Your taxes are paying for today’s beneficiaries, so the benefits you receive will be from someone else’s payroll taxes.
  • You have to think about your payroll taxes as a premium into a retirement account. Just like distributions from retirement accounts, Social Security benefits are also taxable income.
  • Not all of the benefits you will receive will come from the tax you paid to help fund the system. Some of the benefit comes from interest on the trust funds, some comes from taxes collected, and the rest comes from payroll taxes.
  • It’s a “contribution,” not a tax. This allows the IRS to tax you on the money you put into Social Security and the money you receive out as a benefit — because on the way out, it’s technically not a tax. (I don’t care what you call it, it’s a tax! The original Federal Insurance Contributions Act (FICA), the Social Security Administration, and the IRS all explicitly refer to this as a tax.)

All the “reasons” to wave away the double taxation idea that you can easily find online sound like double speak to me. That also piqued my curiosity, so I dove into the research to figure out once and for all whether this is truly a case of double taxation.

Understanding the History of Taxes on Social Security

To understand the whole issue, we have to put some context around this. Let’s back up and look at the history of taxation, how it works and finally answer the question once and for all (although for the purposes of this article, we’ll only look at taxes on the federal level)

Social Security benefits were not taxable from January of 1937, when the first Social Security benefit was paid, until the beginning of 1984. The original thinking was that since FICA taxes are paid with after-tax dollars, the benefit from them should be tax-free.

This all changed as a result of the Greenspan Commission.

(Officially, this was known as the National Commission on Social Security Reform — but it’s commonly called the Greenspan Commission after its chairman, Alan Greenspan.)

Congress and President Reagan appointed this group in 1981 to figure out how to “fix” Social Security. Much like we hear all about today, the Social Security trust fund was also very close to running out of money in the early 1980s.

They had to do something — and fast!

The Introduction of Taxes on Benefits

The Greenspan commission saw taxing Social Security benefits as the low-hanging fruit to solve the problem, despite the fact that there were three separate Treasury rulings in the early days that explicitly excluded Social Security benefits as taxable income.

The rationalization for taxing Social Security benefits was based on how the program was funded. Employees paid in half of the payroll tax from after-tax dollars and employers paid in the other half (but could deduct that as a business expense).

This meant only 50% of payroll taxes were already taxed (the employee portion) and thus up to 50% should be taxable after it was paid.

The Greenspan commission believed this would align the Social Security rules with the ones that already existed for some pensions, annuities, and other retirement savings plans. The way this works is that if you contributed after-tax dollars to your pension or annuity, your pension payments are only partially taxable. You don’t have to pay tax on the portion of the payments that represent a return of the after-tax amount you paid.

The Greenspan commission argued that the portion of the payroll tax that the employer paid was deducted, and thus no taxes were paid on it… which created the loophole to make that portion taxable, but with the recipient of the benefit footing the bill even though the employer initially paid that portion into the system.

In late 1983, a law was passed which made up to 50% of an individual’s benefit count as taxable income.

Once this tax was widely accepted,  it didn’t take long for the federal government to realize that they had been missing billions of dollars in potential revenue. The next step was to increase these taxes again.

Where the Increase in Taxable Benefits Came From

In 1993, a second “level” was added, making up to 85% of a Social Security benefit taxable. The rationalization they used to justify this was different than what the Greenspan commission used just 10 years earlier.

The members of the legislative committees decided that the average worker who lived to an average life expectancy will only contribute 15% of their expected total lifetime benefit in their part of the payroll taxes. Therefore, the other 85% must come from other sources and should be taxed.

For example, say someone earned an average wage and lived until an average life expectancy. They would likely receive a lifetime social security benefit of around $400,000.

But the employee only paid about $60,000 into Social Security. According to their logic, since that’s the only part that’s already been taxed, up to the remainder should be taxable.

Checking the Government’s Math: Unfortunately, They Have a Point

Although I didn’t want to admit it at first, the math here is mostly correct. A worker with average earnings who lives to an average age contributed payroll taxes that equal about 15% of their total expected lifetime benefit amount.

However, this doesn’t hold true if the worker’s income was in excess of the national average wage.

With the same life expectancy, an individual who earned  150% of the national average wage would have contributed approximately 18% of their total benefit. An individual who paid in the maximum Social Security taxes would have contributed around 23% of their lifetime Social Security benefit.  

So…does the taxation of Social Security benefits constitute double taxation? Not unless you earned an income higher than the national average and have enough other income in retirement to have 85% of your benefit taxed.

But if you did…there will be some double taxation on Social Security benefits.

For example, if you worked from 1972 to 2019 and earned maximum wages, your part of the FICA tax to fund Social Security would have been around $190,000. If you file at your full retirement age and live to 85 (and get an average 2% cost of living adjustment), you’ll receive benefits totaling around $834,000.

If 85% of your benefits are taxable, you paid tax on the original FICA contributions plus $708,900 in benefit payments($834,000 x 85%). This means that in the end, you pay tax on $899,000 (85% of benefits + your part of FICA) despite having only received a total benefit of $834,000. Effectively, you get hit with double taxation on $65,000 worth of your benefits.

The Future of Social Security Taxation

If you’re breathing a sigh of relief that you won’t be impacted by double taxation on your benefits, you might not want to rest easy yet.

When Social Security benefits first became taxable, the change only affected the top 10% of retirees in terms of income earners. Now, that number is nearly 60%.

This number will likely continue to increase since the brackets that determine an individual’s income level at which point benefits become taxable has not changed since the law took effect.

In other words, the brackets are still set at 1983 and 1993 levels.

Needless to say, wages have increased between then and now. This becomes even more apparent when you look at the revenue the Social Security Administration is collecting from taxes on benefits; the tax revenue from Social Security has doubled in the last 10 years alone!

There have been a few proposals to eliminate the taxation of Social Security benefits, but with an estimated $13.2 trillion cash shortfall between 2034 and 2092, I can’t envision any proposal succeeding that would reduce revenues for the SSA. Taxes on Social Security benefits are probably here to stay.

But just because taxes may be inevitable for some, you can still plan to lessen the impact. The most obvious strategy would be to simply lower your income — but that’s not appealing or realistic for most of us.

The best option may be to build a strategic plan before you retire. For example, distributions from a Roth IRA or 401(k) are not counted against you in determining whether your Social Security benefits are taxable. You could have an unlimited level of income from these sources and still not pay tax on Social Security.

If you start now, your traditional IRA and 401(k) balances may be able to be converted to Roth accounts.

Could this be an option for you? It may be depending on a number of factors that your financial planner and tax professional can help you unravel. You’ll certainly need to keep the big picture in mind when planning.

If I can help you with your financial planning or investment issues, please don’t hesitate to contact me here.

Questions?

If you still have questions, you could leave a comment below, but what may be an even greater help is to join my FREE Facebook members group. It’s very active and has some really smart people who love to answer any questions you may have about Social Security. From time to time I’ll even drop in to add my thoughts, too. Also…if you haven’t already, you should join the 100,000+ subscribers on my YouTube channel!

The Danger Zone in Social Security Taxation

The gradual phase-in of taxes on Social Security benefits can deliver some unexpected and unpleasant results if you fail to recognize the “danger zone” to avoid. The calculation the IRS uses to determine how to tax Social Security income creates a category where taxes on benefits are amplified.

Fall into this danger zone, and you could pay a much higher tax rate on some of your retirement income. Here’s what you need to know about the taxes on Social Security benefits and how you can avoid the pitfall of paying way too much in taxes on that income.

Know Which Category You’re in for Taxation

Individuals fall into three basic categories for taxation on Social Security:

  1. None of your benefit is taxable income
  2. Between 0% and 85% of your benefit is taxable income (this is the danger zone!)
  3. 85% of your benefit is taxable

In the first category, you have no real need to fear slipping into the danger zone unless you have other income that could push you into the second category.

If you’re in the third category, you have few options to exercise to pay less in taxes.The only real choice you have is to somehow lower your reported income so that you qualify for the first or second category.

This is probably unrealistic, as people who find themselves in the third category are there thanks to large incomes from pensions, required minimum distributions, or some other source. You may need to accept that 85% of your benefit is taxable.

But if you find yourself in the second category, you may have more control over how much of your benefit is taxed.

Understanding the Danger Zone

I call that second category the danger zone because this is where taxes can nearly double on income.

For some, this “danger zone” of magnified taxes can easily be avoided with a strategic, well-thought retirement income plan. The first thing you need to be able to do is to calculate your combined income.

This is the number the Social Security Administration uses to determines how much of your benefit is taxable. It’s also referred to as “provisional income,” but we’ll use the specific term combined income since the Social Security Administration uses that term.

Combined income can be roughly calculated as your adjusted gross income, plus any tax exempt interest (such as interest from tax free bonds), plus 50% of your Social Security benefits.  

Once you’ve calculated your combined income you can apply it to the threshold tables to determine what percentage, if any, of your Social Security benefit will be included as taxable income.

Thresholds for Social Security Taxes If You File Single

If your total combined income is less than the base amount of $25,000, none of your Social Security benefits will be taxed. But if your combined income is between $25,000 and $34,000, up to 50% of your benefit may be taxed.

If your combined income is more than $34,000, up to 85% of your benefits may be taxed.

Thresholds for Social Security Taxes If You’re Married Filing Jointly

If you file a joint return and you and your spouse have a combined income that is less than the base amount of $32,000, none of your benefits will be taxable.

If your total combined income is between $32,000 and $44,000, up to 50% of your benefit is taxable.

If your combined income is more than $44,000 up to 85% of your benefit may be taxable.

This system is a gradual phase-in of tax on Social Security benefits where, as income rises, more of your Social Security benefits are subject to taxation, until eventually a maximum of 85% of all benefits are subject to taxation.

For a more in-depth reading check out my article on the taxation of Social Security benefits.

What Happens to Social Security Taxes in the Danger Zone

Because of the way Social Security income phases into taxation through this formula, there is a “danger zone” when every dollar of increase in combined income pulls more Social Security into taxation.

In this zone, the effective tax rate on this other income skyrockets. For example, if an individual is in the upper end of the danger zone and takes $1.00 from his IRA account, they’ll not only have to pay tax on that $1 but also on $.85 of their Social Security benefit.

Effectively, because they took out $1 they had $1.85 added to their taxable income. This has the effect of increasing the marginal tax rate well beyond what your tax bracket might suggest you are paying.

If your tax bracket is 25% you would ordinarily pay $0.25 on the dollar you took out of your IRA. However, since that $1 increased your taxable income by $1.85, you will have to pay $0.46 in taxes. Since that $0.46 in taxes is solely due to your $1 distribution, you’re paying a 46% tax rate on that dollar!

This whole effect has been referred to as the tax torpedo — but for purposes of this article we’ll refer to it as the “danger zone” since my goal is to help you identify a specific range of provisional income where one should be hyper-vigilant about the effect of taking IRA distributions.

The danger zone ends when the results of your combined income calculation reaches 85% of your social security benefits. At this point, 85% of your benefit will be taxable, so increased combined income will not have the magnified effect.

For example, if you take $1 in IRA distributions it will not expose an additional $0.85 of Social Security benefits to taxable income since your benefit is already taxable.

Also, since all Social Security benefit amounts are not the same, the point where the danger zone ends will be different for everyone. Below we’ll break down the different ranges for those married filing jointly and those filing single.

Where the Danger Zone Ends If You’re Married Filing Jointly

For those who are married filing jointly, exercise caution when combined income income rises over $32,000. At this point, your Social Security benefit will be added to your taxable income at the rate of $.50 for every additional dollar in combined income (signified by yellow on the chart below).

At $44,001 of combined income, your Social Security benefit will begin to be included in taxable income at the rate of $0.85 for every additional dollar in combined income (see the red areas of the bars in the chart below).

You’ll notice that the point at which someone can exit the danger zone varies based on the benefit amount. This is because the exit point is the point where the full 85% of your benefit becomes taxable.

The danger zone ends for those who are married filing jointly at around $88,000 for those who have a maximum benefit in 2019 and half of their benefit is being paid as a spousal benefit.

Getting Out of the Social Security Taxes Danger Zone for Single Filers

You need to start paying attention when your income rises above $25,000. At this point, your Social Security benefit will be added to your taxable income at the rate of $.50 for every additional dollar in combined income (signified by yellow on the chart below).

At $34,001 of combined income, your Social Security benefit will begin to be included in taxable income at the rate of $0.85 for every additional dollar in combined income (see the red areas of the bars in the chart below).

The danger zone ends for single filers around $63,000 in combined income for those with a maximum benefit (2019). For individuals with lower benefit amounts, you’re in the clear sooner.

The Opportunity Zone

In some cases, there is nothing to be done that will help lower the amount of taxes on Social Security. It could be due to required minimum distributions, pensions or a variety of other income sources.

Whatever the reason, some people will simply have incomes that are too high to make it possible to lower back into a zone of less than 85% Social Security taxation.

However, there are opportunities for planning around this danger zone. This opportunity not only exists for those who are in the danger zone, but also for those just over or under the line of the danger zone.

For those just over the line, it may be possible to defer capital gains, IRA distributions, or some other type of income if you could reduce the percentage of your taxable Social Security income by a few points.

Fully understanding how much range you have before Social Security benefits become taxable can be a big help in making choices about realizing capital gains, extra income from a job, or even deciding what type of account to use to fund your travel plans.

If you’re inside the danger zone, be aware that any increase in combined income will have an amplified effect on taxation. Instead of waiting until you are in that zone, there are a few steps you can take before it becomes an issue.

For starters, consider using a Roth IRA. This is possibly the most valuable tool for planning around tax on Social Security. Why? Distributions from a Roth are not counted in your combined income!

If you think you may eventually be in this danger zone, consider building a pool of money in your Roth account. You may be able to contribute to a Roth IRA up to $6,000 ($7,000 if over the age of 50).

Check with your retirement plan at work, as well, to see if they offer a Roth option. Using a Roth in 2019 will allow you to put in up to $19,000 per year ($25,000 if over the age of 50).

Finally, you may want to consider converting traditional IRAs to Roth IRAs. There’s certainly a lot to consider when doing so, but since the tax benefits could extend beyond the tax free nature of the Roth, this could be a winning move.  

One thing is for sure, planning your retirement income stream is worth the effort! If I can be of assistance, please contact me at https://devincarroll.com/contact/

One last thing…I’d like to give a huge thanks to two individuals who helped me with this article. Jim Blankenship, CFP, EA for his expertise on taxation and social security and Brandon Renfro, Ph.D. for his assistance on the research behind these calculations.

Taxes on Social Security

Social Security Tax

Just how much you owe in taxes on your Social Security income can be a huge shock if you’re unprepared.

I vividly remember the fact that the amount of taxes on Social Security was one of my Dad’s biggest retirement surprises.

He didn’t expect to pay so much in taxes, so in his first year of retirement (and first year claiming his benefits) it came as a nasty surprise when he found out that up to 85% of his Social Security benefit could be counted as taxable income!

My dad wasn’t alone. A lot of retirees have no idea of the big tax bill that could be waiting for them in their first spring after retirement.

What to Expect from Taxes on Social Security

Ultimately, in my dad’s situation, we were able to mitigate some of his tax burden. But for the rest of it, he was stuck.

As you can imagine, he didn’t like this one bit. And you might not either if you find yourself in the same position.

Every year individuals retire and are faced with sticker shock when they find out how much they’ll have to pay in taxes on Social Security income.

To some, it doesn’t seem fair. You’ve worked for years and paid your Social Security tax as the admission ticket to a Social Security benefit.

Now that you’re collecting that benefit, you have to pay taxes? Again?

Taxes on Social Security Income Are a Relatively New Thing

At first, Social Security benefits were not taxable. That all changed with the passage of 1983 Amendments to the Social Security Act.

Under this new rule, up to 50% of Social Security benefits became taxable for certain individuals. 10 years later, the Deficit Reduction Act of 1993 expanded the taxation of Social Security benefits.

Under this Act, an additional bracket was added where up to 85% of Social Security benefits could be taxable above certain thresholds.

The combination of these laws left us with the current tax structure on Social Security benefits. Today, somewhere between 0% and 85% of your Social Security payment will be included as taxable income.

Since those brackets have been added, they’ve never been changed! As far as I know, there are no plans to change them in the future. This means that as the general income levels rise, more individuals will be subject to taxation on their social security benefits.

For proof of this, look at what’s already happened. Since taxes on SS benefits were introduced, the revenue coming in from these taxes have skyrocketed. Here’s an example: In 2008, taxes were slightly above 15 billion dollars. In 2017, this amount was 130% higher!

How to Know How Much of Your Benefit Is Subject to Taxes

In order to determine how much of your Social Security benefits will be taxable, you first have to calculate “provisional income.”

I’m not a tax professional, but to my knowledge, the only place this term is found is when it relates to Social Security benefits. It’s a formula by which the IRS determines how much of those benefits you receive should be included as ordinary income on your tax return.

Provisional income can be roughly calculated as your total income from taxable sources, plus any tax exempt interest (such as interest from tax free bonds), plus any excluded foreign income, plus 50% of your Social Security benefits.  

Social Security Tax Provisional Income

Once you’ve calculated your “provisional income” you can apply it to the threshold tables to determine what percentage of your Social Security will be included as taxable income.

If your total “provisional income” is less than $32,000 (or $25,000 if you’re single), none of your Social Security benefits will be taxable.

However, if you are married and your total provisional income exceeds $32,000 (and $25,000 for singles), then 50% of the excess is the amount of Social Security benefits that must be included in taxable income.

If your provisional income exceeds $44,000 (or $34,000 for singles), then 85% of the excess amount is included in income. 

Social Security Provisional Income Threshholds

An Example of How Provisional Income Calculations Work

That can seem really confusing when we’re just talking about things in theory. Let’s look at a more tangible example so you can better understand how taxes on Social Security benefits are calculated.

Imagine that Tim and Donna have recently retired. They have some rental property that generally averages $12,000 in net annual income.

Their combined Social Security benefit will be $3,000 per month, which equals $36,000 per year. In addition to this income, they will take an annual distribution from their IRA in the amount of $32,000.

Retirement Income and Calculating Provisional Income

Using the income from those sources, here’s how the provisional income would be calculated — and remember that only half of the Social Security income is counted in the calculation:

Social Security Provisional Income Calculation

From this, we can see that Tim and Donna have $62,000 worth of provisional income. From here, we can see how much of their Social Security benefit is taxable.

How Your Provisional Income Impacts the Taxes You Pay on Social Security Benefits

Based on a married couple with a provisional income of $62,000, we can return to the thresholds to determine how much in taxes on Social Security they might fact.

The first $32,000 of provisional income has no impact on whether or not a Social Security benefit is taxable. 50% of the amounts between $32,000 and $44,000 will be added and then 85% of the amount in excess of $44,000 will be added.

As a rough calculation, a married couple with a provisional income of $62,000 would have about $21,300 of taxable Social Security income:

dollar amount of Social Security income that is taxable

Since you can only spend the dollars you keep, you need to be familiar with the rules about when and how much you may pay in taxes on Social Security benefits.

You don’t have to be a tax expert; I know I’m not. But I do understand enough to know how to roughly calculate the amount of taxable Social Security benefits — and you should too.

If you need to dig deeper and get specific advice on your situation, please consult your tax advisor or CPA.

Need More Information on Social Security?

If you still have questions, you could leave a comment below, but what may be an even greater help is to join my FREE Facebook members group.

It’s very active and has some really smart people who love to answer any questions you may have about Social Security. From time to time I’ll even drop in to add my thoughts, too. 

You should also consider joining the 100,000+ subscribers on my YouTube channel! For visual learners (as most of us are), this is where I break down the complex rules and help you figure out how to use them to your advantage. 

One last thing that you don’t want to miss: Be sure to get your FREE copy of my Social Security Cheat Sheet. This handy guide takes all of the most important rules from the massive Social Security website and condenses it all down to just one page.