Many people are upset to learn that they may owe tax on Social Security benefits they receive.
After all, they paid Social Security taxes on their income the whole time they were working, why should they now have to pay taxes on their Social Security retirement income?
Before you get too upset, you have to have significant other income before your Social Security benefits become taxable.
Basically, if your only income is from Social Security, then you’re not going to owe any taxes on your benefits.
However, if you have earned income from a job, or if you have substantial investment income, part of your benefits could be taxable.
Here’s how it works: Depending on how much other income you have, up to 50% or even up to 85% of your benefits may be taxable.
There are two base amounts that determine if you will owe tax on your benefits or not. If your combined income is greater than $32,000 (married filing jointly) or $25,000 (single taxpayers), then up to 50% of your benefits could be taxed. If your combined income is greater than $44,000 (married filing jointly) or $34,000 (single), then you could pay taxes on up to 85% of your benefits.
Combined income for purposes of determining whether your benefits are taxed is defined as pension income, wages, interest, dividends and other taxable income, plus 1/2 of your Social Security benefits. Also included is tax exempt interest income so taxpayers can’t invest in municipal bonds to avoid paying taxes on their benefits.
Taxpayers who file married filing separately have to pay taxes on 85% of their benefits, regardless of their other income. This is to avoid married taxpayers from filing separately to try to reduce their taxable income (and thus the taxes paid on Social Security).
Here is an example:
Mary, a single taxpayer, has the following income:
Interest income: $500
Dividend income: $4,000
Pension income (from her deceased husband): $18,000
Right now, it would appear that Mary will not have to pay taxes on any of her Social Security benefits. However, we still need to add in half of her Social Security to come up with the combined income figure.
Assuming that Mary receives $15,000 in Social Security benefits, that brings Mary’s combined income to $30,000 ($22,500 plus 1/2 of $15,000).
Since Mary’s combined income is above $25,000 but below $34,000, she can expect to pay taxes on approximately 50% of her Social Security income.
It is important to understand these rules and income thresholds for a couple of reasons.
First, when you have to take your first required minimum distribution (RMD), you could find that you are above the income limits and have to pay taxes on your Social Security.
Or, if you were planning on converting some traditional IRAs to Roth IRAs during your retirement years, when your tax rate typically is lower, you may find that it’s not an attractive tax strategy after all if it means you will have to pay taxes on 50 or even 85% of your benefits.
The base amounts above were set in 1983 (and amended to add the 85% base amount in 1993). They have never been adjusted for inflation so more and more retirees are finding that they have to pay tax on their retirement benefits each year.
Since Social Security is facing financial difficulties thanks to the large number of baby boomers getting ready to retire, it’s not likely that these base amounts will be adjusted any time soon.
Therefore, careful planning with your tax advisor is needed to minimize the amount of taxes you pay on your retirement benefits.