By Joe Elsasser, CFP
Social Security benefits on their own aren’t subject to federal income tax, however, when you combine Social Security benefits with other retirement income, your total income can fall over the threshold. The Social Security Administration estimates that about 56% of beneficiaries will owe federal income taxes on their benefits. How can you determine who much you’ll owe? Start by calculating your provisional income.
Provisional income includes half of your Social Security benefits, plus all other taxable income like dividends, realized interest, and realized capital gains. All non-taxable interest earnings like municipal bonds should be added as well.
If you file a federal tax return as an individual and your provisional income is between $25,000 and $34,000, you may have to pay income tax on up to 50% of your benefits. If your provisional income is more than $34,000, and you’re filing as an individual, up to 85% of your benefits may be taxable.
If you’re married and filing jointly, you may have to pay income tax on up to 50% of your benefits if your provisional income falls between $32,000 and $44,000. If your combined income exceeds the $44,000 threshold, up to 85% of your benefits may be taxable.
Once you determine the provisional income, subtract the first threshold and multiply by .5. Then subtract the second threshold and multiply by .35. Add up the results. If the total amount is less than the maximum, that is the taxable amount. If the total amount is greater than the maximum, the taxable amount is the max.
Many people believe that exceeding the first threshold automatically makes a full 50% of their Social Security benefit taxable. That’s not the case. Instead, only 50% of the amount over the threshold becomes taxable.
Here’s an example:
A married couple are filing taxes jointly. They have $40,000 in Social Security benefits and $30,000 in IRA withdrawals. To calculate their provisional income, we take half of their Social Security benefits ($20,000) and add it to the $30,000 of IRA withdrawals. They have $50,000 of provisional income.
We then subtract $32,000–since that’s the first threshold for married couples, and multiply by .5. This gives us $9,000. Next, take the provisional income ($50,000) and subtract the second threshold for married couples ($44,000) and multiple by .35 which equals $2,100. Add the $9,000 and the $2,100 for a total of $11,000 in taxable benefits.
It’s important to note that compared to other income, Social Security has a significant tax-advantage. At worst, 85% of benefits are taxable and 15% are tax-free.
Understanding your different retirement income streams and how they interact is crucial. Middle-income retirees can create tax-efficient retirement strategies by making conscious decisions about which accounts to withdraw from at different points in retirement–including Social Security. A good financial advisor help you determine how much of your benefit could be taxable and guide you on which account to use and when to help you reach your retirement goals.
About the author: Joe Elsasser, CFP®
Joe Elsasser, CFP® is the founder and president of Covisum®, a financial tech company focused on creating software solutions, practice management and marketing resources to help advisers and financial institutions grow and improve lives through better retirement decisions. Covisum helps financial advisers serving mass-affluent clients in or near retirement and powers some of the nation’s largest financial planning institutions.