social security benefits – Social Security Intelligence

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:

None of your benefit is taxable income
Between 0% and 85% of your benefit is taxable income (this is the danger zone!)
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, be sure to get your FREE copy of my Social Security Cheat Sheet. This is where I took the most important rules and things to know from the 100,000 page Social Security website and condensed it down to just ONE PAGE! Get your FREE copy here.

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.

We’re taking a look at the math behind a social security strategy that’s been around for a while. Here it is: File early, invest the monthly benefit, and you’ll be able to generate more income than someone who waited until later to file.

Effectively…you can do better on your own. But does it make sense to file early and invest the money?

A Decade of Positive Returns Creates Optimism in Investing

There’s nothing like a decade of positive returns in the market to create optimism for investing. We’re starting to see this optimism affect how individuals file for social security.

A few years ago, there weren’t many people saying they were big believers in the market. We were still recovering from the worst market since the Great Depression, and news was still (mostly) negative.

A few years later, individuals started seeing a few years of positive returns. Some of those have been double digit returns, and optimism began rising.

And so I’ve started to hear more people say things like “Devin, I think I could file early for Social Security, invest it, and create more income down the road than what I would’ve had with Social Security.”

So, You Think You Can Do Better?

Now, I’ve heard things like that for a while, but I’ve never gotten into the numbers to see what was really possible. So…I decided it was time for a closer look.

Let’s consider someone with a $2,000 benefit at their full retirement age. For this example, we’ll assume full retirement age is 67.

You can file as early as 62 and get $1,400 or as late as 70 and get $2,480.

Let’s look at two scenarios: First one is where you need to start your income at 67; and the other is where you need to start your income at 70.

In both cases, I’ll assume that you file for benefits at 62. That benefit has a 2% cost of living adjustment (COLA) applied and that you invest the monthly benefits check.

Here’s how that investment would accumulate at various rates of return from the beginning if age 62 to the beginning at age 67:

First, let’s assume you didn’t make anything. That $1,400 would be worth $87,427. At 4, 6 and 8 percent it would gradually increase and the highest rate of return I assumed was 10 percent where your balance would be $116,985. These amounts would be the available balance to use in supplementing your income.

So now let’s look and see what the income gap would be after we adjust for the annual cost of living adjustments. Your benefit would start at $1,400, but by age 67, it would be approximately $1,546 if there was a 2% annual COLA.

The age 67 benefit was $2,000, but when you add the COLA to it, that amount would now be $2,208. So there would be an income gap of $662 that you would need to create from the invested Social Security benefits.

I’m assuming there are two ways to generate this income. First, is an immediate lifetime annuity. This is the closest thing to your Social Security benefit in that it offers a fixed payment that’s guaranteed for your lifetime. The way these work is that you give a lump sum of money to an insurance company and they send you the payments. The other option I assumed was leaving your money invested and taking a 5% annual withdrawal to supplement the income.

And The Results Are In

Here were the results: If you need to generate an income stream of $662 per month, it would require an annuity of $115,539 and an investment portfolio of nearly $160,000.

For the annuity, this would mean that you’d have to achieve an annual return of 10% and for the portfolio option you’d need to get a return of 21%.

Keep in mind…these are the returns needed to break even. You’d have to exceed that to do better that what you’d get with almost no risk from the Social Security administration. I’m not sure how you feel about your capabilities to get consistent investment returns like these, but if you can…maybe you should start a hedge fund. I can tell you that there’s no way I would take that chance with a client’s money.

What If You Invest It For A Longer Period of Time… Does That Work Out?

But what if you have a longer time period?

Let’s say that you don’t need the income to start until you’re 70. In this scenario, you’d have from the beginning of age 62 to the beginning of age 70 to receive benefits and invest them. How would the time/value of money change the outcome?

By the time you take your age 70 benefit, it would have grown to $2,905 with an annual 2% cost of living adjustment. That’s an income gap of $1,265 you’d need to cover. Since you’d have a few additional years to invest, the balance of the investment portfolio would be higher than in the prior scenario ranging from 144,000 to 224,000 at 10% annual return.

Now we know you may have saved, but how much would it take to replace $1,265?

You need an annuity of $200,000, and an investment portfolio of around $300,000. This means that for the annuity to work you’d need to get about a 7% return and for the portfolio to work you’d need about a 17% return.

Again…those numbers are just to give you the dollar amount of income that you’d get from Social Security without taking hardly any risk. And, the risk is not the only difference here.

For example, the annuity options do not have survivor benefits, the taxation of an annuity vs. investment portfolio vs. social security is all different so the net amount would not be the same. The annuity options were calculated with today’s interest rates and there’s just no way to know what the interest rates would be in the future and how these annuities would be affected. The investment returns I illustrate are compounded annually and would be slightly different if compounded on a monthly basis. The amount of your social security benefit would also affect the required rate of return on the other options.

This article is based on what we know today with a set benefit amount, but your mileage may vary with your own circumstances.

It’s Your Retirement!

Ultimately, remember…I’m not your financial, legal or tax advisor. This article is meant to help educate you, but not as specific advice for your specific situation. I’d highly recommend that you keep learning and stay curious!

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!