Your Social Security benefits could be subject to federal income tax. This fact may seem unfair, or even unfathomable, but it is a reality for many Americans.
Social Security taxes can reduce your monthly net income, forcing you to spend more of your savings to maintain the same standard of living in retirement. However, you can take steps to minimize the impact of these taxes if you understand the applicable laws.
Seniors have contended with the possibility of Social Security taxes since 1984.
The 1979 Advisory Council on Social Security determined that Social Security benefits should be treated more like pension payments than social services for tax purposes. This idea became the basis of a 1983 law that implemented federal income taxes on a portion of Social Security benefits.
Since the law took effect in 1984, individuals with income above a certain threshold have owed tax on 50% of their Social Security benefits. A second income threshold was added in 1993 which requires Social Security recipients with higher incomes to pay tax on 85% of their benefits.
Unfortunately for retirees, the income thresholds for Social Security benefit taxation have not increased since their implementation. Consequently, the number of Americans who owe tax on their Social Security payments has steadily increased. In fact, only 8% of Social Security recipients had total incomes high enough to trigger the tax in 1984 compared to 52% of households receiving benefits in 2015.
Only part of your Social Security income may be taxable, not all of it.
As previously mentioned, Social Security benefits are only taxable if your income exceeds certain limits. Your income for this tax is calculated using a special formula called Provisional Income – also known as Combined Income.
Social Security defines your combined income as the sum of your adjusted gross income, any non-taxable interest earned, and 50% of your Social Security benefit income. If your combined income is above the following thresholds, you will owe tax on a portion of your benefits.
- Tier 1: 50% of Social Security benefits are subject to federal income tax.
- Applies to single filers with combined income between $25,000 and $34,000.
- Applies to joint filers with combined income between $32,000 and $44,000.
- Tier 2: 85% of Social Security benefits are subject to federal income tax.
- Applies to single filers with combined income above $34,000.
- Applies to joint filers with combined income above $44,000.
Additionally, recipients who are married filing separately will likely owe tax no matter how much income they receive.
You may be able to estimate and pay Social Security taxes in advance.
You can use the worksheet in IRS Publication 915 to estimate the amount of income tax you will owe on your Social Security benefits. This form can be difficult to understand, so you may need to enlist the help of an experienced financial advisor that specializes in Social Security.
If your income is above the applicable threshold, you can choose to have taxes withheld from your Social Security benefits. The available withholding options are 7%, 10%, 12%, and 22% per payment. There is not currently an option to establish withholding online, so you must complete IRS Form W-4V and return it to your local Social Security Administration office. Alternatively, you can make estimated tax payments per quarter, like business owners are required to do.
Did you know that 12 states also tax Social Security payments?
In addition to federal income tax, certain states levy an income tax on Social Security benefits. These states are New Mexico, Utah, Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, North Dakota, Rhode Island, and Vermont. West Virginia also imposed an income tax on Social Security benefits in the past, but it was phased out in 2022.
What can you do if it appears your benefits will be taxed?
If your combined income is far greater than the $34,000 single filer or $44,000 joint filer threshold, your chances of averting tax on Social Security income are slim. On the other hand, if your combined income is near the threshold, there are several strategies you could use to reduce your taxable income.
Revise Your Portfolio
One strategy for reducing your provisional income is to revise your portfolio. For example, you could invest in securities that aim to increase in value without paying interest each year. This strategy seeks to reduce your provisional income while still leaving the option to sell your investments if needed.
Take Advantage of Charitable Distributions
If revising your portfolio doesn’t fit with your investment goals, you could consider a qualified charitable distribution from your IRA. This type of distribution is available if you are age 70½ or older and allows you to give up to $100,000 per year directly to a qualified charity. The amount of the gift will not be counted in your adjusted gross income – plus it may satisfy your Required Minimum Distribution [RMD].
Make Tax-Exempt Withdrawals When Appropriate
Another option to reduce your taxable income is to withdraw from Roth accounts rather than Traditional. Distributions from Roth IRAs and Roth workplace retirement plan accounts are tax-exempt as long as you are age 59½ or older and have held the account for at least five tax years.
The strategies discussed above don’t work for everyone, and their effectiveness is determined by your unique situation. For this reason, be sure to discuss your options with an experienced financial advisor before implementing them.
Will the income limits linked to taxation of Social Security benefits ever be raised?
Retirees can only hope that the income limits for tax on Social Security benefits will be raised in the future. However, with more baby boomers becoming eligible for Social Security, the IRS and the Treasury stand to receive greater tax revenue with the current limits in place.
With the income thresholds stable for now, it is important to work them into your financial plan. This way, you can minimize the impact of taxes on your retirement income.
Prepare for Social Security Taxes with Financial Fingerprint™
At Meld Financial, we have the tools and experience to help you determine if you will be subject to tax on your Social Security benefits. If our analysis shows that you will owe these taxes, we can help you make a plan to minimize your tax burden.
Tax management is just one part of our comprehensive wealth management program – Financial Fingerprint™. It covers all the important aspects of your financial life from choosing wise investments to ensuring your retirement income lasts a lifetime.
To learn more about Financial Fingerprint™ and get started today, contact us.
