Think that upon retirement and getting that first Social Security check in the mail you’re in the clear as far as the IRS is concerned? Hold on just a minute. The reality is that a good part of your Social Security payment could be taxed. If you are technically ‘retired’ but still working and receiving Social Security the reality is that your Social Security payment will be lumped on top of your other income and potentially (and likely) taxable. About 25 million Americans pay income taxes on their Social Security benefits every year.
There are many types of incomes retirees receive that are subject to ordinary income taxes. All of this income can trigger taxes on Social Security benefits — which can come as an unwelcome surprise. Many retirees have other sources of income besides retirement accounts. A such, it’s important to remember that taxable income includes self-employment income, as well as unearned income such as dividends and interest, capital gains and U.S. Savings Bonds. Alimony, unemployment compensation, gambling winnings or lottery winnings are additional sources of taxable income.
To determine whether your Social Security benefits in retirement will be taxed, the IRS uses what it calls your ‘combined income’ — which is the sum of your adjusted gross income (AGI), non-taxable interest, and half of your Social Security benefits. If your combined income exceeds a certain limit, 50 to 85 percent of your benefits may be taxed.
First, the initial threshold is when your benefits are totally tax free. This is when your combined income is less than $25,000 and you file a single or head-of-household tax return. That threshold rises to $32,000 if you file a joint return.
Second, no more than half of your benefits can be taxed if your combined income is between $25,000 and $34,000 on a single return or between $32,000 and $44,000 on a joint return. The amount included in taxable income is either half of your benefits or half of the amount by which combined income exceeds the trigger point — whichever is less.
Third, when your combined income exceeds $34,000 on a single return or $44,000 on a joint return, 85% of your benefits will be taxed in almost all cases.
Let’s look at two examples for a hypothetical Social Security tax bite to a retiree:
Say you and your spouse file a joint return. Your AGI for the year is $30,000, and you have $4,000 of tax-free interest income from municipal bonds and $5,000 of Social Security benefits. Adding your AGI ($30,000), your tax-exempt interest ($4,000) and half of your Social Security benefits ($2,500) gives you a combined income of $36,500. That’s $4,500 over the $32,000 threshold for joint returns. Since half of that amount ($2,250) is less than half your benefits ($2,500), the smaller amount becomes taxable income. In the 15% bracket, the $2,250 will cost $337.50 in extra federal income tax.
Consider how the tax hits the higher-income beneficiary. Let’s say your AGI is $80,000 and you and your spouse receive a total of $25,000 in benefits. The maximum 85% ($21,250) would be taxed, costing you $5,312.50 in extra federal income tax in the 25% bracket. Most states that have an income tax don’t touch Social Security benefits.
The attached article, “5 Ways to Avoid Taxes on Your Social Security Benefits” from Kimberly Lankford at Kiplinger’s, identifies strategies for limiting taxes on Social Security benefits in retirement. Giving your Required Minimum Distribution (RMD) to charity, buying a Qualified Longevity Annuity Contract (QLAC) and owning a Roth IRA where distributions are not taxed are three strategies for reducing or eliminating Social Security Taxes in Retirement.