Saturday, February 9, 2013

Will Your Social Security Benefits Be Taxed?


Most people don’t think about having to pay income taxes on Social Security retirement benefits after they retire. Most of us won’t have to pay them.

But many of us will. If you begin receiving Social Security benefits and you have saved a lot for retirement or have a job, you may see a dramatic increase in your marginal tax rate.

Who Won’t Have to Pay?

If you haven't saved enough for retirement and all or most of your retirement income will come from Social Security benefits, your benefits won’t be taxed. That's good news and bad, of course.

The bad news is that you would no doubt prefer to have a lot of money so taxes could be your biggest problem.  The good news is that you won’t pay taxes on your Social Security benefits and you won't need to read the mind-numbing tax discussion in the rest of this post.

(For your sake and mine, I hope you’re still with me.)

What Could Make your Benefits Taxable?

Technically, nearly any form of income in addition to Social Security benefits except Roth IRA distributions could push you over the limits, but here are some likely culprits:
  • Large IRA account balances, especially after age 70 ½
  • Large taxable (non-retirement) account balances
  • Large investments in municipal bonds
  • Pensions
  • Employment
  • Inflation (more on that in a minute)
In fact, unless you have a fairly large retirement savings portfolio (perhaps $250,000 or more) or you are employed after you begin receiving benefits, you probably won’t pay taxes on your Social Security benefits. Income from a job or distributions from a large retirement account, however, can push you to the level of income where Social Security benefits become taxable. Perhaps painfully so.

When Do Benefits Become Taxable?

If your “combined income” exceeds a “base amount” of $25,000 a year and you are single (or $32,000 and married filing jointly), some of your Social Security benefits will be taxed.

What is “combined income”? There’s a good chance that you’ve never heard of it.

The Social Security Administration defines combined income as the sum of half your Social Security benefits plus Adjusted Gross Income from your federal income tax return plus non-taxable interest.
For example, if you receive $12,000 a year from Social Security retirement benefits, have an adjusted gross income of $10,000, say from interest and dividends, and earn $4,000 in tax-free municipal bond interest in a given year, your combined income will be:
You would fall below the $25,000 lower base amount and none of your Social Security benefits would be taxable that year. Here's a nifty calculator if you want to play with the numbers.

Adjusted Gross Income (AGI) is basically the sum of all your annual income including wages, capital gains, dividends, pensions, interest, IRA distributions and just about any other taxable income source. AGI doesn’t include tax-free interest, but combined income does. When you add tax-free income, combined income includes just about every form of income you might have, except for Roth IRA distributions.

Traditional IRA distributions are included in AGI, so when you take money out of your IRA, which you will eventually have to do, it might push your Social Security benefits into a taxable bracket. 

Distributions from a Roth IRA are not included in combined income. They’re about the only safe refuge.

In other words, it’s very difficult to protect income from contributing to Social Security benefit taxability. You can’t just invest in muni’s like you do to avoid federal income tax before you receive benefits.

(I’ll show you how to calculate combined income in more detail in my next post.)

Taxing Benefits Increases Your Marginal Tax Rate

Why is this a problem? When Social Security benefits become taxable, the additional taxable income can push your marginal tax bracket significantly higher. Your marginal tax bracket can increase to over 50% when you include state taxes, but it is more likely to increase 20% to 30%, and less in some cases.

This is also important because you must begin taking Required Minimum Distributions (RMDs) from your IRA accounts when you reach age 70 ½. That additional income could cause your Social Security benefits to become taxable. The net effect, a high marginal tax rate created when mandatory IRA withdrawals make your Social Security benefits taxable, is sometimes referred to as the “tax torpedo”, but that’s a long story for another post.

Inflation Will Catch More and More Households

Another important consideration when thinking about the taxability of Social Security benefits is inflation. While Social Security benefits are generally increased to compensate for inflation, those base amounts ($25,000/$32,000 for single and $32,000/$44,000 for married filing jointly) are not.

If inflation runs 3% a year for the next 10 years and Congress doesn’t change the law, that lower limit will be $18,600 in today’s dollars. In 20 years it will be less than $14,000. Your retirement could last even longer than that and that limit will become easier and easier to surpass.

As with the Alternative Minimum Tax, the number of households paying taxes on Social Security benefits will increase over time.

Avoiding Social Security Taxability is an Annual Battle

Social Security benefit taxability is calculated every year. Benefits may be taxable one year because you take some large capital gains but not taxable the next year when you don’t. They may not be taxable when you are 65 and leaving your IRA untouched, but taxable when you are 71 and forced to take RMDs.

I’m not a tax expert, but if you believe your benefits might become taxable, I would suggest you find one to help with your retirement planning. There are steps you can take to reduce these taxes, like converting to a Roth IRA, delaying Social Security benefits, and changing the order in which you spend from taxable, tax-deferred and Roth accounts. Which steps to take depends heavily on your own situation, so do the analysis before deciding. Better yet, have a tax expert analyze it.

Taxability of Social Security benefits is one more good reason to delay receiving benefits as long as you can if you have substantial retirement savings — those benefits won’t become taxable, of course, until you start receiving them.


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