Calculating Taxable Social Security Benefits

In my last post, Will Your Social Security Benefits Be Taxed?, I promised to show you how to calculate combined income in greater detail. Combined income is the number that determines how much of your Social Security benefits, if any, will be taxed. As I explained in that post, the basic equation is this:

The following diagram shows some of the types of income included in combined income. Almost all income will be, including tax-free interest. (The list of AGI items is representative, but not complete.) About the only income not included in combined income is a distribution from a Roth IRA account.

The core of combined income is Adjusted Gross Income. Perhaps the best way to get an understanding of AGI is to look at the first page of your Form 1040 from last year (or this blank form). AGI will be the last line on the first page. That’s line 37 for 2011 returns.

AGI is calculated by adding up the rightmost column of the “Income” section at the top of the first page of Form 1040 and subtracting items from the “Adjusted Gross Income” section at the bottom. Notice that AGI includes all the blue items in the diagram above and more.

Tax-exempt (tax-free) interest is listed on line 8b of Form 1040, but is not included in the AGI total on line 37. It is, however, included in combined income.

Combined income also includes half your Social Security benefits. Line 20b is where you would enter taxable Social Security benefits.

In 2011, your combined income would have been the sum of lines 37 and 8b from the first page of your Form 1040, plus half your Social Security benefits.

While you can easily figure your combined income with this calculator, it’s handy to understand how the amount is determined. There are two base amounts for combined income depending on your marital and filing status. The following diagram shows the single return filer base amounts on the left and married-filing-jointly base amounts on the right.

Let’s pretend this diagram is a bucket and you are a single filer. To determine how much of your Social Security benefits are taxable, you would calculate combined income as I explained above and then “pour” this combined income into the bucket.

The portion of your combined income in the green part of the bucket will result in no taxation of your Social Security benefits. 

$0.50 of every dollar of combined income that rises into the pink area will be taxable. 

Should your combined income fill the bucket into the red area, $0.85 of every dollar that rises into the red area will be taxable and $0.50 of every dollar in the green area (all $9,000 of them) will be taxable.

For example, if you had $34,100 of combined income, your taxable Social Security benefits would equal 50% of $9,000 plus 85% of $100, or $4,585. $27,000 of combined income would result in 50% of $2,000, or $1,000 of your Social Security benefits being taxed.

There are a couple of important things to note here that might seem obvious to you, but have caused some confusion for many.

First, what we just calculated is the amount of your Social Security benefits that will be taxable, not the amount of the tax. The IRS isn’t going to take 50% or 85% of your benefits in taxes. That amount is added to your taxable income and the amount of taxes you will pay depends on your tax bracket.

In the first example above, if you calculated that $4,585 of your Social Security benefit would be taxable and you were in a 15% tax bracket, your actual additional tax would be 15% of $4,585, or about $688.

The second thing to note is that only the portion of your combined income that exceeds the base amount is taxed. Exceeding the $25,000 hurdle doesn’t automatically render 50% of your benefits taxable. If you have $25,001 of combined income, only 50% of one dollar of your benefits becomes taxable.

What does this do to your marginal tax rate, the amount of tax you pay on the last dollar of income you receive? This depends on what your marginal tax rate would be if no Social Security benefits were taxable. Your new marginal tax rate will be 150% of that rate if you exceed only the first base amount and 185% of that rate if you exceed the second. A 25% marginal tax rate would increase to 37.5% in the first case and 46.3% in the second. State taxes may increase these rates further.

The structure of the tax tables limits married-filing-jointly marginal tax rates to 27.75%, so only those filing single returns are subject to that monster 46.3% marginal rate that could exceed 50% when you add state taxes.

It’s complicated to be sure, so use a calculator like this one to play around with the possibilities and consult a tax professional to develop a plan to minimize your taxes.

In my next post, I’ll discuss some ways you might minimize the impact of taxable Social Security benefits.