The Taxation of Social Security Benefits
During the recent presidential campaign, one of the talking points that came up was to eliminate income taxes on any Social Security benefits.
This campaign pledge sparked much discussion. On the one hand were those who were surprised to find out Social Security was subject to tax at any level, while others vehemently insisted that taxing it was just wrong (and some were in both camps).
Given this discussion and laying aside the fact that this tax was implemented to help shore up the depleting trust fund that pays such benefits and how to replace the lost revenue that would occur if the tax was eliminated, I felt a primer on how all this works might be insightful to those interested.
The amount of your Social Security benefits, if any, that are taxable depends on your total income and marital status, and how much of those benefits gets zapped can be a sliding, if somewhat confusing, scale. Anywhere from nothing all the way up to 85% of the benefits received could be taxable.
That said, generally if Social Security is your only income, your benefits are not taxable and you probably do not even need to file a federal income tax return. If, however, you received income from other sources, your benefits will be taxed once your modified adjusted gross income is more than the "base amount" for your filing status.
Here's a quick computation to determine whether some of your benefits may be taxable:
First, add one-half of the total Social Security benefits you received to all your other taxable income (including capital gains), adding in also any tax-exempt interest and dividends you receive.
Then, compare this total to the base amount for your filing status. If the total is more than your base amount, some of your benefits may be taxable. The base amounts are:
- $32,000 for married couples filing jointly.
- $25,000 for single, head of household, qualifying widow/widower with a dependent child, or married individuals filing separately who did not live with their spouse at any time during the year.
- $0 for married persons filing separately who lived together during the year.
The surprise for many comes when they have gone for years not paying any tax on their benefits, but then have an unexpected source of income in one or more years. This could be something like a one-time sale of property, inheritance of an IRA or similar account from which taxable distributions are taken.
These unexpected sources of income can push the taxpayer over the base amount and cause taxes to kick in on the benefits too. In effect, it's a double tax whammy because you not only pay the required tax on the regular income, but now also on the Social Security benefits.
Or perhaps you acquire in some way, like an inheritance, a portfolio of tax-exempt securities. No problem right, after all they are tax-exempt? Think again! Look back above at the base amount formula and see how even tax-exempt income can cause a problem.
Fortunately, there are some planning tips that may be able to help you reduce or eliminate this tax on benefits.
For example, if you are planning a one-time property sale at a substantial gain as mentioned earlier, consider structuring it as an installment sale with payments stretched out over a number of years. The taxable gain will be likewise stretched out over time and may can be timed so as not to throw your Social Security benefits into the taxable range.
Another idea, if you have substantial retirement savings in taxable accounts is to convert those accounts to Roth IRAs before you start taking Social Security. Yes, you will be taxed on the conversions, but future Roth IRA distributions are not taxable and therefore can't cause your Social Security benefits to be taxed. In same case, the savings later may justify the tax cost now on conversion.
Finally, if you are still working when reaching Social Security retirement age, consider delaying the receipt of benefits until age 70. You not only will receive a higher benefit by doing so, but if you stop working at that point, it's possible you won't have enough other income to cause taxation of your benefits.
Thankfully, many states, Arkansas being one, treat Social Security benefits as completely tax-exempt, thus not adding further insult to what many consider a tax injury.
