Hey everyone! Today I want to cover the basics of Social Security taxation. As you are planning for or living in your retirement this is crucial to understand. Also, this topic is from a recent poll where you asked for more information regarding social security taxes.
Don’t Be Taken By Surprise
How much you owe in taxes on Social Security income can be a big shock.
I clearly remember that it was one of my Dad’s biggest retirement surprises. He didn’t expect to pay so much in taxes. Yet there it was…a big whopping tax bill in the first year of retirement. Like a lot of other retirees, he knew that some of his Social Security benefit could be counted as taxable income, but he wasn’t real familiar with the rules on what determined the amount of taxes.
This wasn’t isolated to him. 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?
The Social Security Act
Originally, Social Security benefits were not taxable as income. This was not due to the way the original Social Security Act was written, but rather the result of a series of administrative rulings issued by the Treasury Department.
There were three separate Treasury Rulings, two from 1938 and one from 1941. During the years 1937-1939, two types of Social Security benefit were paid:
- Lump-sum retirement payments to retired workers; and
- Lump-sum death benefits to the family of deceased workers.
So there are two 1938 tax rulings, one covering lump-sum retirement payments and one covering lump-sum death payments.
In 1939, the Social Security Act was amended and dramatically expanded to include survivors’ and dependents’ benefits of various types. In a 1941 ruling, the Treasury Department explicitly extended its earlier rulings to these new types of benefits.
In 1970, the prior rulings were reaffirmed. However, in 1983 Congress changed the law by specifically authorizing the taxation of Social Security benefits. This was part of the 1983 Amendments, and this law overrode the earlier administrative rulings from the Treasury Department.
The Deficit Reduction Act
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.
In order to determine how much of your Social Security benefits will be taxable, you first have to calculate “provisional income” – a measurement of income used specifically for this purpose of determining how much of your benefit is taxable.
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 50% of your Social Security benefits. 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 ($25,000 if single), none of your Social Security benefits will be taxable. However, if you are married and your total exceeds $32,000 then 50% of that excess is the amount of Social Security benefits that must be included in taxable income.
Provisional Income In Action
If your provisional income exceeds $44,000 ($34,000 for singles), then 85% of the excess amount is included in income. That can seem confusing so let’s look at an example.
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 ($36,000 a year). In addition to this income, they will take an annual distribution from their IRA in the amount of $32,000.
Using the income from those sources, here’s how the provisional income would be calculated. First, we have the $32,000 IRA distribution. Then we have the $12,000 in net rental income, and then we have their Social Security benefit. And remember that only 1/2 of the Social Security income is counted.
Based on these numbers, they have a provisional income of $62,000. Now that the provisional income is calculated, it’s time to find out how much of their Social Security benefit is taxable which is accomplished by applying the income to the thresholds we previously discussed.
As we move this 62,000 in provisional income through the thresholds, remember …the first $32,000 of the 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. 85% of the amount in excess of $44,000 will be added.
In the column on the far right I’ll put the results of the calculation which is the amount of Social Security that is taxable. So, you can see that the first 32,000 adds nothing. The amount between 32k and 44K is 12,000, of which half is counted, so $6,000 gets added to taxable Social Security. There is still 18K remaining about the 44K line and that gets added at 85% which is an additional $15,300 in taxable social security.
When you add this up you see that as a rough calculation, a married couple with a provisional income of $62,000 would have $21,300 of taxable Social Security income. This means that for Tim and Donna, they would have 60% of their total benefit subject to taxation.
Reach Out To Your Tax Advisor
Since you can only spend the dollars you keep, you need to be familiar with the rules about how much you may pay in taxes on Social Security. You don’t have to be a tax expert…I know I’m not. I do understand enough to know how to roughly calculate the amount of taxable Social Security benefits. You should too. For anything deeper, see your tax advisor. High taxes in retirement is a surprise that can often be avoided.
Before we go I want to thank you for taking the time to get informed. So many people just float into retirement hoping everything will work out. Sometimes it does, but sometimes a lack of planning can ruin what should be your best years. This is your retirement! Please continue to stay informed!
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Question: Do you think your social security benefits should be taxable?
Thanks for reading…have a great day.