A central part of retirement funding for most individuals is the Social Security retirement benefit. Workers contribute a portion of their life-time earnings from employment in taxes to fund the benefits and this contribution is matched by the employer (or the worker, if self-employed). There is much discussion in the financial advice industry about when a worker should apply for those benefits and how the amount received will be affected by the worker’s age when the benefits start. Suffice it to say that the earliest one can take their benefit is at age 62 and the benefit generally will increase every year one waits until their age 70 when the largest benefit would be available. What does not seem to receive as much attention, however, is the question of whether and how much of the Social Security benefit will be subject to income tax.
Many workers do not understand that as much as 85% of their Social Security benefits may be included in their taxable income, with the likely result being a diminished amount actually available to fund retirement spending once those additional taxes are taken into consideration. The starting point in determining the amount of benefits which will be included in taxable income is calculating provisional income, a number including one-half of the Social Security benefits and all other sources of income. If this number is below the base amount of $25,000 for taxpayers filing individually or $32,000 for married taxpayers filing jointly, then none of the Social Security benefit will be included in taxable income. This is a low threshold, the impact of which is magnified by the fact that the base amount is NOT adjusted for inflation unlike many other tax thresholds, such as the income tax brackets, the annual gift exclusion amount and contribution limits to qualified retirement plan accounts.
The next step is to determine whether provisional income falls below $34,000 for taxpayers filing individually or $44,000 for married taxpayers filing jointly. In this case, a fifty percent inclusion rule applies so that an individual taxpayer would include up to $4,500 of benefits ($34,000 - $25,000 x 50%) and married taxpayers up to $6,000 of benefits received. Again, this threshold is not adjusted for inflation and remains a fairly low bar for calculating the inclusion of benefits.
When provisional income exceeds the higher threshold of $34,000 for individual taxpayers and $44,000 for married taxpayers filing jointly, up to 85% of Social Security benefits may be included in taxable income. Lower total incomes will see some benefit from the 50% bracket for inclusion but substantially greater incomes will result in inclusion in taxable income of a full 85% of the Social Security benefits received. The good news, such as it is, is that no more than 85% of those benefits will be subject to taxation under these rules. However, as you can see, adding in those benefits may result in your moving into a higher tax bracket.
The calculations and the amount of benefits ultimately taxed are highly dependent not only on total income (not the provisional income discussed above) but also the amount of the Social Security benefit. Obviously, the lower the total Social Security benefit received, the lesser the impact of its inclusion on the overall tax picture. Those taxpayers liable to see the greatest impact are those with a relatively high benefit coupled with significant income from other sources.
Your accountant will be able to help you understand what to expect in terms of inclusion and your tax burden as well as what level of withholding, if any, may be recommended for your Social Security benefits. Remember, it is only a percentage of your benefits that may be included in taxable income and the actual tax due will depend on your tax bracket after all income and deductions are factored into the return.
George Chamberlin & Mentor RIA Consulting © 2019