Are Social Security Benefits Taxable?
Calculating the taxable portion of social security income and strategies to reduce it.
Retirees and those planning for retirement often ask if social security benefits are subject to federal income tax. Unfortunately, the wholly unsatisfying answer is, “It depends.” 0%, 50% or 85% of social security benefits will be included in taxable income depending upon a recipient’s annual “combined income” (defined below). However, there are planning strategies that can reduce “combined income,” and limit the taxable amount of a recipient’s social security benefits.
“Combined Income” and Its Effect on the Taxability of Social Security Benefits
In order to determine the amount of social security benefits included in taxable income, a recipient’s “combined income” must be calculated. The Social Security Administration calculates “combined income” as follows:
Adjusted Gross Income (AGI)
+ Non-taxable Interest
+ 1/2 Social Security Benefits
“Combined Income”
AGI includes wages, self-employment, pension, interest, dividend, and any other income that must be reported on a tax return. Required minimum distributions from pre-tax retirement plans, combined with social security benefits, can drive “combined income” higher beginning when a taxpayer turns 72, the age when annual RMDs become mandatory.
Non-taxable interest is usually the interest earned on tax-free municipal bonds. Generally speaking, a taxpayer will not be taxed on the interest income earned on municipal bonds (There are caveats to this statement, so consult with a professional if you have questions). However, this interest is an add-back item when calculating “combined income.” Could one argue that the inclusion of municipal bond interest in “combined income” raises a question regarding it “tax-free” nature? Absolutely, but that is a subject for a different article. For now, just be aware that municipal bond interest is included in this calculation.
Once the “combined interest” amount has been calculated, the taxable amount of social security benefits will be determined by the taxpayer’s filing status.
Single taxpayer – If a single taxpayer’s “combined income” is less than $25,000, no amount of the social security benefits will be included in taxable income. Between $25,000 and $34,000, 50% will be included. For those with “combined income” over $34,000, 85% of their social security benefits will be included in taxable income.
Married Filing Joint Taxpayers For married filing jointly taxpayers with “combined income” of less than $32,000, no amount of the social security benefits will be included in taxable income. Between $32,000 and $44,000, 50% will be included. For those with combined income over $44,000, 85% of their social security benefits will be included in taxable income.
Strategies to reduce taxes on social security benefits.
Given the relatively low threshold amounts for the inclusion of social security benefits in taxable income, planning around reducing its taxability can be difficult, but not impossible.
Use of Roth IRAs
Taxpayers are able to take distributions from their Roth IRAs income tax-free. These Roth IRA distributions are also excluded from the calculation of “combined income.” Given this dual benefit, it is important for pre-retirees to reposition their retirement assets into Roth IRA accounts as early and as tax-efficiently possible.
Delaying Filing for Benefits
The full-retirement age for social security benefits is 66 or 67, depending upon a recipient’s birth-year. This is the age when an individual will receive their full monthly social security benefit. Individuals are able to file for benefits as early as age 62, but will receive a reduced monthly amount if they do so. Alternatively, delaying filing until age 70 can increase a recipient’s benefit beyond the full-retirement amount to the maximum. On its own, the simple act of delaying filing for social security can increase the recipient’s economic benefit.
There is also a not-so-obvious strategic opportunity in delaying filing for social security benefits. Between the ages of 62 and 70, taxpayers can take strategic distributions from their taxable retirement accounts, and live off the proceeds during those years. If they have sufficient cashflow from other sources, they can convert pre-tax balances to Roth IRA balances. Distributing or converting has a two-fold benefit. First, it can help households make the ends meet during the years social security benefits are being delayed. Secondly, it will reduce future required minimum distributions from taxable accounts, effectively reducing the “combined income” in years when the taxability of social security benefits is calculated.
(The decision to delay social security depends upon many factors in addition to the ones noted above. Evaluate your situation carefully to see what makes the most sense for you.)
Qualified Charitable Distributions
Qualified charitable distributions are payments made from a retirement account directly to a charity. The use of these QCDs is a very power strategy, because it satisfies the annual RMD requirement, but does not increase account owner’s “combined income.” Unfortunately, a taxpayer must be over the age of 70.5 to qualify for QCDs, and there are annual limits and other considerations. However, when strategically used, these QCDs can be a powerful tool for reducing “combined income”.
Conclusion
The taxation of social security benefits is a complicated subject area in financial planning. The earlier a pre-retiree begins planning, the easier it will be to minimize the related taxes during their retirement.
About the author:
JP Geisbauer is a Certified Public Accountant and a Certified Financial Planner ®. He is the founder of Centerpoint Financial Management, LLC, a retirement planning, investment management, and tax planning firm located in Irvine, CA. If you have specific questions regarding your situation, please schedule a complimentary 30-minute call here.
Disclaimer:
This article is for general information and educational purposes only. Nothing contained in this article constitutes financial, investment, tax or legal advice. Before taking any action on any topic discussed in this article, please consult with your financial planner, investment advisor, tax professional, and/or attorney for advice on your specific situation.