How are Social Security Benefits Taxed?
If you are approaching retirement you are probably wondering how your social security benefits will be taxed. Like most tax questions, the answer is depends on the taxpayer’s specific circumstances.
Depending on your income level, up to 85% of your social security benefits may be taxed. This doesn't mean you pay 85% of your benefits back to the government in taxes-merely that you would include 85% of the benefit in your income subject to your regular tax rates.
To determine how much of your benefits are taxed, you must first determine your other income, including certain items otherwise excluded for tax purposes (for example, tax-exempt interest). Add to that the income of your spouse, if you file jointly and half of the Social Security benefits you and your spouse received during the year. The figure you come up with is your total income plus half of your benefits. Now apply the following rules:
1. If your income plus half your benefits is not above $32,000 [$25,000 for single taxpayers], none of your benefits are taxed.
2. If your income plus half your benefits exceeds $32,000 but is below $44,000, you will be taxed on (1) one half of the excess over $32,000, or (2) one half of the benefits, whichever is lower.
For example (1): Sam and Catherine have $20,000 in taxable dividends, $2,400 of tax-exempt interest, and combined Social Security benefits of $21,000. Thus, their income plus half their benefits is $32,900 ($20,000 plus $2,400 plus 1/2 of $21,000). They must include $450 of the benefits in gross income (1/2 ($32,900 − $32,000)). (If their combined Social Security benefits were $5,000, and their income plus half their benefits were $40,000, they would include $2,500 of the benefits in income: 1/2 ($40,000 − $32,000) equals $4,000, but 1/2 the $5,000 of benefits ($2,500) is lower, and the lower figure is used.)
The formula for single taxpayers is slightly different. Item 2 above is changed as follows when computing for a single taxpayer.
2. If your income plus half your benefits exceeds $25,000 but is below $34,000, you will be taxed on (1) one half of the excess over $25,000, or (2) one half of the benefits, whichever is lower.
For example (1A): Sam has $20,000 in taxable dividends, $2,400 of tax-exempt interest, and Social Security benefits of $9,000. Thus, his income plus half his benefits is $26,900 ($20,000 plus $2,400 plus 1/2 of $9,000). He must include $950 of the benefits in gross income (1/2 ($26,900 − $25,000)). (If his Social Security benefits were $3,000, and his income plus half his benefits were $30,000, he would include $1,500 of the benefits in income: 1/2 ($30,000 − $25,000) equals $2,500, but 1/2 the $3,000 of benefits ($1,500) is lower, and the lower figure is used.)
When Your Income Plus ½ of Your Benefits Exceeds $44,000
When your income plus half your benefits exceeds $44,000 ($34,000 for single taxpayers), the computation in many cases grows far more complex. Generally, however, unless your income plus half your benefits is fairly close to $44,000 ($34,000 for single taxpayers), if you fall into this category, 85% of your Social Security benefits will be taxed.
Don’t Be Surprised With a Higher Tax Bill
If you aren't paying tax on your Social Security benefits now because your income is below the above floor, or are paying tax on only 50% of those benefits, an unplanned increase in your income can have a triple tax cost. You'll have to pay tax (of course) on the additional income, you'll also have to pay tax on more of your Social Security benefits (since the higher your income the more of your Social Security benefits that are taxed), and you may get pushed into a higher marginal tax bracket.
This situation might arise, for example, when you receive a large distribution from a retirement plan (such as an IRA) during the year or have large capital gains. Careful planning might be able to avoid this stiff tax result. For example, it may be possible to spread the additional income over more than one year, or liquidate assets other than an IRA account, such as stock showing only a small gain or stock whose gain can be offset by a capital loss on other shares. If you should need a large amount of cash for a specific purpose, contact your tax advisor before liquidating any assets to estimate what your additional tax cost will be.
We once had a client that took a large IRA distribution to pay medical bills. This client was surprised with the significant increase in taxes during that year resulting from the higher income level and the increase in the amount of his social security benefits that were taxed. It was even more difficult for the client to handle when he discovered that he was unable to itemize the most of the medical expenses that were paid with the IRA distribution due to the floor on medical expense deductions. A little planning in this situation could have saved our client taxes. Simply deferring the payment of the medical expenses until the following year would have allowed him to itemize most of the medical expenses.
If you know your social security benefits will be taxed, you can voluntarily arrange to have the tax withheld from the payments by filing a Form W-4V. Otherwise, you may have to make estimated tax payments.