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.
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 then they are stuck paying tax on thousands of dollars in Social Security income that they thought was tax-free.
Below, 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.
- Social Security income benefits can be taxed up to 85%, depending on total annual income. Also, 13 states individually tax Social Security income.
- The simplest way to keep your Social Security benefits free from income tax is to keep your total combined income so low it falls beneath the thresholds to pay tax.
- Reducing taxation can also happen through optimizing the retirement accounts that you place your savings and the order in which you tap those assets for income.
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:
|Taxable Social Security Income|
|Filing Status||Income||Percentage of Social Security That Is Taxable|
|Single, Head of Household, Qualifying Widower, and Married Filing Separately (where the spouses lived apart the entire year)||Below $25,000||All Social Security income is tax free.|
|Same||$25,000 to $34, 000||Up to 50% of Social Security income may be taxable.|
|Same||More than $34,000||Up to 85% of Social Security income may be taxable.|
|Married Filing Jointly||Below $32,000||All Social Security income is tax free.|
|Same||$32,000 to $44,000||Up to 50% of Social Security income may be taxable.|
|Same||More than $44,000||Up to 85% of Social Security income 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.)
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 may thus have to pay taxes on up to 50% of his Social Security.
Henry and Sharon Hill have joint earned income of $48,000, plus $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 Hills' MAGI is thus $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. For 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 may be 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.
The solution could thus 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 a reportable interest of $0 when computing provisional income.
Generally, annuities become taxable income when they are taken as distributions depending on the account type. Virtually any investor who is not spending all of the interest paid from a CD or other taxable instrument can thus benefit from moving at least a portion of his or her assets into a tax-deferred investment or account.
Earmarking Retirement Accounts
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.
A leading way is to withdraw funds early—or "make distributions," in the retirement parlance—from your tax-sheltered retirement accounts, such as IRAs and 401(k)s. Keep in mind that you can make distributions penalty-free after age 59½. That means you avoid being dinged for making these withdrawals too early, but you must still pay tax on the amount you withdraw.
Since any withdrawals are taxable, they must, of course, be planned carefully with the other taxes you will have to pay on income for the year. The goal is to pay less in tax by making more withdrawals during this pre-Social Security period than you would after you begin to draw benefits. That requires considering the total tax bite from withdrawals, Social Security benefits, and any other sources.
Be mindful, too, that at age 70½, you're required to take minimum distributions (RMDs) from these accounts, so you need to plan the funds for those mandatory withdrawals.
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.