The quick answer is “it depends.” But, for the 33 percent of retirees who now rely more heavily on their Social Security benefits to sustain their lifestyle, the answer takes on even more significance. Generally, your income from Social Security is not taxable on its own; but when it's combined with other sources of income for tax reporting purposes, a portion of your Social Security benefits, up to 85 percent, could be includable as taxable income. Unfortunately, over 40 percent of retirees aren't aware that their benefits could possibly be taxed, and it is always a rude awakening when it happens.
Having an understanding of how Social Security benefits could be taxed might enable you to consider ways to reduce the impact. So the real question becomes, “under what circumstances are my Social Security benefits taxable?”
Generally, any income from employment, a pension, IRA withdrawals, interest on savings, even interest on tax exempt bonds is combined along with half of your Social Security income to determine the taxable portion. The only sources of income that are not included are monthly payments from an annuity or withdrawals from a Roth IRA.
If the total amount is $25,000 ($32,000 for joint filers) or less, you get to keep all of your benefits. However, if your combined income, including half of their Social Security income, is between $25,000 and $34,000 ($44,000 for joint filers) up to 50 percent of your benefits are subject to taxes. Anything above $34,000 ($44,000 for joint filers) will trigger a tax on up to 85 percent of your benefits.
As an example, John and Elaine have an adjusted gross income (AGI) of $58,000 and receive combined Social Security benefits of $24,000. This increases their includable income from $58,000 to $70,000 (Total income + half of Social Security benefits). This puts them $26,000 over the upper $44,000 threshold, thereby subjecting $20,400 (85% cap of the 26,000 above the upper threshold). With that, their AGI is adjusted upward, from $58,000 to $78,400!
If your Social Security income becomes taxable, it will be taxed at your marginal income tax rate. Most states don't apply the same tax rules for Social Security income, but some do, so, check with your state's tax agency. If you anticipate that your Social Security income will be taxable, you can elect to have a part of it withheld just as you did with tax withholding on your paycheck; or you can make quarterly estimated payments.
If you think you might find yourself in this situation, contact us. We can provide a more detailed analysis of your income situation, and we can explore some possible strategies for reducing your exposure to the Social Security tax.
Brian Teets is the Founder of Safe Haven Wealth Management of Wyandotte, MI