Congress’s complicated rules for the taxation of Social Security benefits open the door to opportunities to save.
It used to be so simple. From the time the first checks were issued in 1937 through the end of 1983, Social Security benefits were tax-free. Period. Beneficiaries didn’t even have to report the money on their tax returns. But no more. Today’s beneficiaries fall into one of three categories:
If you’re among the 25 million or so Americans whose Social Security retirement benefits are likely to be hit, you need to know the rules. The first step in determining whether you are vulnerable is to compute your provisional income. That’s basically your adjusted gross income (not counting any Social Security benefits), plus any tax-exempt interest, plus 50% of your benefits.
Your benefits are totally tax-free if your provisional income is less than $25,000 if you file a single or head-of-household return. The threshold rises to $32,000 if you file a joint return. (Unlike many other thresholds in the tax law, these figures are not indexed to rise with inflation. And that’s not an oversight. Congress did it deliberately so that, over time, more and more beneficiaries would be subject to the tax.)
If your provisional income exceeds the threshold for your filing status, just how much of your benefits will be taxed depends on how high your income is. If it is between $25,000 and $34,000 on a single or head-of-household return or between $32,000 and $44,000 on a joint return, no more than half of your benefits can be taxed. The amount included in taxable income is either half of your benefits or half of the amount by which provisional income exceeds the trigger point—whichever is less. Assume you are married and file a joint return with your spouse. Your AGI for the year is $30,000, and you have $4,000 of tax-free interest income from municipal bonds and $5,000 of benefits. Adding your AGI ($30,000), your tax-exempt interest ($4,000) and half of your benefits ($2,500) gives you a provisional income of $36,500. That’s $4,500 over the $32,000 threshold for joint returns. Since half of that amount ($2,250) is less than half your benefits ($2,500), the smaller amount becomes taxable income. In the 15% bracket, the extra $2,250 will cost $337.50 in extra federal income tax.
When provisional income exceeds $34,000 on a single return or $44,000 on a joint return, things get more complicated, but the bottom line is this: In almost all cases, 85% of your benefits will be taxed. The IRS has devised an 18-line worksheet for figuring out how much of your benefits are taxable. You’ll find it in the instructions (www.irs.gov/pub/irs-pdf/i1040gi.pdf) for your tax return.
What about married couples who file separate returns? They can forget the $25,000/$32,000 and the $34,000/$44,000 thresholds. Their threshold is a big fat $0—and they can be certain that 85% of their Social Security benefits are taxable. Although our example of how the 50% rule works may make the tax seem relatively benign, consider how the tax hits a higher-income beneficiary. Let’s say your AGI is $80,000 and you and your spouse receive a total of $25,000 in benefits. The maximum 85% ($21,250) would be taxed, costing you $5,312.50 in extra federal income tax in the 25% bracket. There’s good news at the state level. Most states that have an income tax don’t nick Social Security benefits, and in those that do, a portion remains tax-free. Be sure to check the rules in the state where you plan to retire.
If your benefits are threatened, some planning can help limit the bite. If your AGI will include amounts withdrawn from a traditional IRA, for example, you may be able to stagger withdrawals to vary your income from year to year so that your benefits are taxed only in alternate years. An advantage of the Roth IRA is that because qualified withdrawals are tax-free, the money can’t push more of your Social Security benefits into the taxable range. Timing the sale of stocks or other appreciated property can pay off, too. For example, you could take profits in years when 85% of your benefits will be taxed anyway and limit gains in intervening years to reduce the amount of benefits that are taxed.
These strategies can be more important than they appear. Remember, when your provisional income is between $25,000 and $34,000 on a single return or between $32,000 and $44,000 on a joint return, earning an extra dollar causes 50 cents’ worth of benefits to be taxed. Adding $100 to your income, then, allows the IRS to tax $150. In the 15% bracket, that costs you $22.50—boosting your effective tax rate to 22.5%. If your provisional income is higher, an extra $100 of income can make $85 of benefits taxable. Taxing $185 at 25% costs you $46.25, the same as taxing your extra $100 of earnings at 46.25%.
Some retirees have dumped their municipal bonds because they consider the fact that tax-free income can trigger a tax on benefits a form of backdoor taxation of bond income. That strategy can backfire, however. If you switch to a comparable taxable investment, it will probably deliver a higher yield that could push even more of your benefits into the taxable range.
If it’s okay with you, Social Security will be happy to withhold income tax from your benefits, just like your boss withholds pay from your salary. Although it might seem crazy to let Uncle Sam dip into your benefits, it may make sense if it lets you avoid making quarterly estimated payments of the tax due on your benefits or other taxable income. To request withholding, file a Form W4-V (www.irs.gov/pub/irspdf/fw4v.pdf) with the Social Security Administration. Withholding will be a flat 7%, 10%, 15% or 25%, whichever you choose. Estimate how much you want withheld, then do the math to figure which withholding rate to request.
Douglas Finley, MS, CFP, AEP, CDFA founded Finley Wealth Advisors in February of 2006, as a Fiduciary Fee-Only Registered Investment Advisor, with the goal of creating a firm that eliminated the conflicts of interest inherent in the financial planner – advisor/client relationship. The firm specializes in wealth management for the middle-class millionaire.
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