In the good old days Social Security was tax free. But times have changed, and now many taxpayers can expect to see at least a portion of their Social Security income make its way onto the taxable income line of their 1040s.

TUTORIAL: Traditional IRAs

People who convert their Traditional IRAs to Roth IRAs often fall into this hidden trap. If they exceed the funding limit, the extra income pushes them beyond the income threshold level and boom! They are stuck paying tax on thousands of dollars in Social Security income they thought was tax free. In this article we\'ll explore why and how Social Security benefits become taxable and provide some tips to help you dig your way out of the trap. (To learn more about Social Security benefits and eligibility, read Introduction To Social Security.)

Income Thresholds
There are two separate income thresholds for filers that will determine whether they have to pay tax on their Social Security benefits. Here is a breakdown of the categories:

- Income Percentage of Social Security Taxable
Single, Head of Household, Qualifying Widower and Married Filing Separately
(where the spouses lived apart the entire year)
Below $25,000 All SS income is tax-free
$25,000 - $34,000 Up to 50% of SS income may be taxable
$34,000 and up Up to 85% of SS may be taxable
Married Filing Jointly Below $32,000 All SS income is tax-free
$32,000 - $44,000 Up to 50% of SS income may be taxable
$44,000 and up Up to 85% of SS may be taxable

Calculating Your Income Level
Filers in either of the first two categories must compute their provisional income - also known as modified adjusted gross income (MAGI) - by adding together tax-exempt interest (such as from municipal bonds), 50% of the year\'s Social Security income, as well as any miscellaneous tax-free fringe benefits and exclusions to their adjusted gross income and then subtracting adjustments to income (other than education-related and domestic activities deductions.)

Example 1
Jim Lorman is single, he earned $19,500 for the year and received $2,000 of interest income and $1,500 from gambling winnings. He also receives $10,000 in Social Security income. ($19,500 + $2,000 + $1,500 + $5,000 = $28,000)
  • Jim\'s provisional income will come to $28,000. He therefore may have to pay taxes on up to 50% of his Social Security.

Example 2
Henry and Sharon Hill have joint earned income of $48,000 and $4,000 of interest and $3,000 of dividends. Their Social Security benefits come to $20,000. ($48,000 + $4,000 + $3,000 + $10,000 = $65,000)

  • The Hill\'s MAGI is therefore $65,000. They may have to pay tax on up to 85% of their Social Security benefits.

You can use IRS publication 915 to estimate the amount of taxable Social Security income you will have. Qualified plan participants who also contributed to a deductible IRA must use the worksheets found in IRS Publication Form 590 instead. Those who file as Married Filing Separately and lived at any time with their spouse during the year, IRS publication 915 states that up to 85% of your Social security maybe taxable regardless of the sum.

How to Lower Your Social Security Taxes
There are several remedies available for those who are taxed on their Social Security benefits. Perhaps the most obvious solution is to reduce or eliminate the interest and dividends that are used in the provisional income formula. In both of the examples shown above, the taxpayers would have reduced their Social Security tax if they hadn\'t had declarable investment revenues on top of their other income.

Therefore, the solution could be to convert the reportable investment income into tax-deferred income, such as from an annuity, which will not show up on the 1040 until it is withdrawn. If you have $200,000 in certificates of deposit (CDs) earning 3%, which translates into $6,000 a year that will be counted as provisional income. But the same $200,000 growing inside an annuity, with the interest reinvested back into the annuity, will effectively yield reportable interest of $0 when computing provisional income. Generally, annuities become taxable income when they are taken as distributions depending on the account type. Therefore, virtually any investor that is not spending all of the interest paid from a CD or other taxable instrument can benefit from moving at least a portion of his or her assets into a tax-deferred investment or account. (For more on annuities, check out An Overview Of Annuities and Passing The Buck: The Hidden Costs Of Annuities.)

Another possible remedy could be to simply work a little less, especially if you are at or near the threshold of having your benefits taxed. In the first example listed above, if Jim were to move his taxable investments into an annuity and earn $1,000 less, he would have virtually no taxable benefits. Shifting investments from taxable accounts into a Traditional or Roth IRA will also accomplish the same objective, provided funding limits have not been surpassed. (For more on the problems that can happen with an IRA conversion, see How IRA Contributions Affect Your Taxes and IRA Rollover Mistakes.)

The Bottom Line
There are many rules concerning the taxability of Social Security benefits, and this article attempts to cover only the major rules and issues related to this topic. For more information on this topic, visit the IRS website and download IRS publication 915 or consult your tax advisor.

Related Articles
  1. Professionals

    7 Tips for Year-End Financial Planning

    There is always a rush to get financial planning tasks done at year's end. Here are some tips to help ease the crunch.
  2. Professionals

    Top Tips for Helping Clients Through a Divorce

    It may take a delicate touch to properly assist clients who are going through a divorce. Here are some tips.
  3. Professionals

    How Legacy Planning Can Help Capture New Clients

    Don’t underestimate the importance of legacy planning with your clients—it could serve as method for you to create new business with any heirs.
  4. Professionals

    How to Navigate Taxable Mutual Fund Distributions

    It's almost time for year-end capital gains distributions for mutual funds. Here's how to monitor them and minimize their tax impact.
  5. Taxes

    The Top 10 Caribbean Tax Havens

    Discover relevant tax policy information about the top 10 tax havens located in the Caribbean, including the Cayman Islands and the Bahamas.
  6. Stock Analysis

    3 Stocks that Are Top Bets for Retirement

    These three stocks are resilient, fundamentally sound and also pay generous dividends.
  7. Professionals

    Tips for Retaining Your Client's Heirs

    It's a good idea to start working with your clients' children early on to forge relationships and hopefully continue to manage that wealth.
  8. Investing

    10 Ways to Effectively Save for the Future

    Savings is as crucial as ever, as we deal with life changes and our needs for the future. Here are some essential steps to get started, now.
  9. Professionals

    3 Benefits of Working Longer (and Retiring Later)

    There are many reasons why folks in their 60s may want to keep working until at least age 70. Here are three.
  10. Professionals

    How to Get Free Social Security Spousal Benefits

    Married couples should thoroughly examine whether they are eligible to collect free spousal benefits on their Social Security income.
  1. Are Cafeteria plans taxable?

    Whether the benefits you receive through your employer-sponsored cafeteria plan are taxable depends entirely on which benefits ... Read Full Answer >>
  2. Can I borrow from my annuity to put a down payment on a house?

    You can borrow from your annuity to put a down payment on a house, but be prepared to pay an assortment of fees and penalties. ... Read Full Answer >>
  3. Why is the Cayman Islands considered a tax haven?

    The Cayman Islands is one of the most well-known tax havens in the world. Unlike most countries, the Cayman Islands does ... Read Full Answer >>
  4. Why is Luxembourg considered a tax haven?

    Luxembourg has been the tax haven of choice for many corporations and mega-rich individuals around the world since the 197 ... Read Full Answer >>
  5. What are the main kinds of annuities?

    There are two broad categories of annuity: fixed and variable. These categories refer to the manner in which the investment ... Read Full Answer >>
  6. What are the risks of rolling my 401(k) into an annuity?

    Though the appeal of having guaranteed income after retirement is undeniable, there are actually a number of risks to consider ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!