When it comes to Social Security benefits financial advisors need to understand the tax implications and be in a position to advise their clients accordingly.

Combined Income

At the federal level, the taxation of Social Security benefits is based upon something called combined income. This is calculated as your client’s adjusted gross income (AGI) plus any non-taxable interest plus half of your client’s Social Security benefit. (For more, see: How to Navigate Social Security with Your Clients.)

Clients who earn a significant amount of interest from municipal bonds, which are generally tax-exempt for federal purposes, will be “penalized” in this calculation. Certainly any decision in terms of a client’s use of muni bonds should be made in the overall context of their situation and not just based upon their impact on the taxation of Social Security benefits. For example, a client couple has the following situation:

  • Their combined Social Security benefits are $25,000
  • Their AGI from their tax return is $36,000
  • They received $10,000 in tax-exempt income.

Their combined income to determine the taxability of their Social Security benefit is:

Half of their Social Security benefit (50% of $25,000)                   $12,500

+ AGI                                                                                             $36,000

+ Tax-exempt income                                                                    $10,000

Combined income                                                                         $58,500

This would put them in the range where up to 85% of their benefit could be taxed, as discussed in the next section. (For more, see: How Married Couples Can Maximize Social Security.)

Federal Taxes

The formula to determine if and at what rate your client’s Social Security benefits will be subject to federal income taxes is as follows:

  • For individual filers with combined incomes between $25,000 and $34,000 for 2016, up to 50% of their Social Security benefit will be subject to income taxes.
  • For individual filers with combined incomes over $34,000, up to 85% of their Social Security benefit will be subject to income taxes.
  • For joint filers with combined incomes between $32,000 and $44,000, up to 50% of their Social Security benefit will be subject to income taxes.
  • For individual filers with combined incomes over $44,000, up to 85% of their Social Security benefit will be subject to income taxes.

In no instance will more than 85% of an individual’s Social Security benefit be subject to federal income taxes. These limits are in place for everyone drawing a Social Security benefit, regardless of age. (For related reading, see: Tips on Delaying Social Security Benefits.)

State Income Taxes

Most states do not tax Social Security benefits, but 13 states do. The rules and exemptions vary widely across this group. Financial advisors with clients in these states can provide them with appropriate advice. These states are:

  • Colorado
  • Connecticut
  • Kansas
  • Minnesota
  • Missouri
  • Montana
  • Nebraska
  • New Mexico
  • North Dakota
  • Rhode Island
  • Utah
  • Vermont
  • West Virginia

Working and Social Security Taxes

Working in retirement is more and more common for any number of reasons. Many retirees seek the mental stimulation of full or part-time work. Some need the income. Others want to start that encore career that has little or nothing to do with their career during their working years. In some cases, people will retire and then return to work, either out of boredom or financial necessity. Whatever the reason, if your clients are drawing a Social Security benefit and are also working it is important that they understand the tax implications. (For more, see: The Lowdown on Working During Retirement.)

Any money earned from wages or self-employment income is subject to the same income taxes as when your client was working prior to retirement. They will be subject to any withholdings that are applicable based upon their income for federal or state income taxes as well as withholdings for Social Security and Medicare. Additionally, as discussed in the prior section, your Social Security benefit could be subject to income taxes depending upon your income level.

For those who have not yet reached their full retirement age (FRA), which is 66 for those who were born prior to 1960, earned income over the threshold set each year by the Social Security Administration could cause a reduction in their benefits for that year. For 2016 the income threshold is $15,720. Any earned income above this level will result in a reduction of your benefit by one dollar for every two dollars of income earned. (For more, see: How Advisors Can Manage Evolving Retirement.)

In the year that the benefit recipient will reach their FRA, the threshold jumps to $41,880 of earned income and the benefits reduction is $1 for every $3 earned over the limit. Once the recipient reaches their FRA the limit on earned income goes away. If your client does have their benefit reduced due to earning too much income for working, they will get this money back via an increased benefit when they reach their FRA so the money is not lost.

Benefit Do Over

If you file for your benefit and then change your mind you have one lifetime “do-over” which is called a withdrawal of application - if, within 12 months of commencing your benefit, you decide that you want stop receiving your benefit. In order to do this, you must repay all benefits received, including those received by family members based upon your earnings record. Your benefits will stop and you can resume them at a later time. (For more, see: Social Security File and Suspend Claiming Strategy is Ending: Now What?)

If you are already eligible for Medicare, you have options concerning your coverage. If you make this decision after the 12-month window, your only other alternative is to wait until you reach your FRA and suspend your benefit. Take note that with the changes in the Social Security rules, those suspending benefits after April 30, 2016 will no longer be able to suspend retroactive benefits, nor will anyone else be able to draw a benefit based upon your earnings record if you suspend your benefits.

Tax Considerations

One of the considerations for a client in deciding when to take their benefits are the tax implications. This is especially the case for clients who may be considering taking their benefits prior to age 70 and who will have significant other income.

The Bottom Line

The impact of taxes on Social Security benefits is misunderstood by many recipients. There are a number of financial planning opportunities here. Financial advisors can play a key role in helping clients factor this into their benefits claiming decision and can help them manage their tax liability once benefits commence. (For more, see: Social Security Changes for 2016.)

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