Taxation of Social Security Benefits

About 1 in every 2 adults will pay federal income taxes on a portion of their Social Security benefits this year.

The thresholds for paying a portion of the benefits back in year-end taxes are relatively low, meaning almost everybody with another form of substantial income from wages, interest, dividends, or other taxable income will be writing the IRS a check.

History

As a part of the Greenspan Commission (whose task was to shore up the Social Security Administration’s massive year-over-year deficits), taxes on Social Security were introduced in 1983. The thresholds were not (and are not) indexed for inflation. As prices and wages have increased substantially since the Commission’s final meeting, the thresholds have not increased in a similarly linear fashion. This makes it very difficult to avoid paying taxes and will become more so as the years progress.

What are the thresholds?

If filing “individually”, and a combined income* of

  • $25,000 – $34,000, up to 50% of your benefits may be taxable
  • More than $34,000, up to 85% of your benefits may be taxable

If filing a joint return, and a combined income* of

  • $32,000 – $44,000, up to 50% of your benefits may be taxable
  • More than $44,000, up to 85% of your benefits may be taxable

*Combined Income = adjusted gross income (AGI) plus nontaxable interest, plus one-half of your Social Security benefits.

How to reduce Social Security taxes

It is difficult, but not impossible, to reduce the taxes owed for Social Security. To reduce the taxes owed, one needs a lower Combined Income*. Lowering one’s AGI by taking distributions from a Roth IRA instead of a Traditional IRA is by far the most common. Unlike Traditional IRAs and 401ks, Roth accounts allow for tax-free distributions (if over the age of 59½ and the account is more than 5 years old). Additionally, certain life insurance policies and reverse mortgages may provide cash flow while reducing the amount of income tax on Social Security benefits. 

Have a plan for Social Security taxes

Frequently, first time receivers of Social Security benefits don’t know the laws around their taxation and may be surprised by a big bill when tax season rolls around. The worst part is, the bill comes at the beginning of the year, after the prior year’s benefits have already been spent. There’s a simple way to avoid this: plan for it.

Before taking the benefits (or at the time of first receipt), estimate the likely amount of income being received for the year. This will provide an accurate measure of how much of the benefits being received will go back to the government at the end of the year and how much can be spent or saved. Additionally, many recipients change their withholding rate using a Form-W4V, requesting a certain percentage of their total benefit amount to be withheld for future tax payments.

It is important to note that 37 states do not tax Social Security at the state-level, including Florida. The 13 that do are Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont, and West Virginia.

Conclusion

Failing to prepare for the likely event of paying taxes on the prior year’s Social Security benefits can lead to a great deal of stress, worry, and frustration. Simply taking the time to understand how much of the benefits are yours to keep can greatly reduce the chances of a future headache. Estimate your combined income*, look for your tax threshold, and don’t spend more than you’re going to keep.

Don’t lose perspective, 15% of Social Security income is tax-free. If you find yourself in the large group of taxpayers, know that your discipline in your younger years set you up for a well-funded retirement. Well done.

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