Retirement and Taxes: Part 1 (Social Security)
Contrary to a common belief, Social Security benefits are not automatically tax-free. The idea of “100% tax free Social Security benefits” persists because things used to be that way in the original design of the Social Security plan. Nothing lasts forever, so 50% of Social Security benefits became subject to income tax in 1983. In 1993, the potentially taxable portion of your check expanded to the maximum of 85%.
How does this affect you and your family? The answer depends on your specific circumstances, but there are three common points of impact you should be aware of.
Impact: Tax on Social Security Benefits
The first one is the actual income tax on the Social Security benefits. The “back of the napkin” method for doing a quick calculation is to take your total income from all taxable sources, add in tax-exempt interest from bonds and one half (50%) of your Social Security benefits. The result is labeled “provisional income”.
The next part gets a little tricky.
If “provisional income” exceeds $25,000 for an individual or $32,000 for a married couple filing a joint return (we will call this Bracket 1), then 50% of the excess is the amount of Social Security benefits that must be included in taxable income.
If provisional income exceeds $34,000 for individuals or $44,000 for married couples (we will call this Bracket 2), then 50% of the amount between Bracket 1 and Bracket 2, as well as 85% of the excess amount above Bracket 2, must be included in taxable income.
The maximum portion of taxable Social Security benefits is capped at 85%.
By now, you are probably thinking that if this is the “easy” estimation method, you don’t want to ever see the full calculation. Confused? That’s OK. Let’s go through a couple of real examples to help you figure this out.
Example 1: Relatively simple.
James and Laura receive $16,000 from running a small business renting kayaks to visiting seniors, and $40,000 from Social Security. Following the above method,
$16,000 + (50% of $40,000) = $36,000.
“Provisional income” of $36,000 exceeds Bracket 1 amount of $32,000 for a married couple by $4,000. Therefore, 50% of that excess amount (or $2,000) of Social Security income will be taxable.
Example 2: A little more complex.
Steve receives $24,000 in income from his rental property, $1,000 in interest income from tax-exempt bonds, and $30,000 from Social Security. Following the method above,
$24,000 + $1,000 + (50% of $30,000) = $40,000.
The resulting “provisional income” of $40,000 exceeds the limit of Bracket 2 ($34,000 for those filing single) by $6,000.
Therefore, 50% of Bracket 1 (half of the difference between $25,000 and $34,000, or $4,500), plus 85% of the amount over $34,000 (85% of $6,000 is $5,100) make the total of $9,600. That is the amount of Steve’s Social Security income that is subject to tax.
Bottom line: most people should expect that a portion of their Social Security benefits will fall into the “taxable” category. That means that a portion of those benefits must be set aside to pay taxes.
Impact: Marginal Tax Rates
Marginal tax rate is the percentage of additional income you must set aside for taxes.
Why should you care about marginal tax rates? As your tax accountant has undoubtedly told you, life decisions have tax consequences. Therefore, your financial decisions outside of the Social Security realm can result in a higher portion of your Social Security income being taxable.
Let’s illustrate it with an example.
We will revisit James and Laura from the example above, but now assume that they decided to take $5,000 out of their IRA to take their grandkids to Japan.
Their new provisional income is $16,000 + $5,000 + (50% of $40,000) = $41,000. That provisional income exceeds Bracket 1 limit of $32,000 by $9,000. Now, 50% of that (or $4,500) is the taxable part of the Social Security benefit. Compare that with their “original” taxable amount of only $2,000.
Therefore, the couple’s decision to take an IRA distribution has cost them not only having to pay taxes on that $5,000 distribution, but also owing more tax on their Social Security benefits.
Assuming that they are in a 15% tax bracket, they will owe an additional $1,125 ($5,000 + $2,500, times 15%). That may not look terrible, but remember that they only got “true” additional income in the amount of $5,000 (which was their IRA distribution). That means they are paying the marginal tax rate of 22.5%, or $1,125 divided by $5,000. Almost a quarter of that IRA distribution will be going towards paying the tax bill – which is a helpful thing to know before you take that distribution.
Impact: Tax Brackets
Let’s start with some background. Everyone falls into a specific set of tax rates depending on their taxable income. Right now, there are 7 tax brackets. The new tax reform proposal by President Trump would reduce that number to 4, but we will leave that potential development aside for the moment because there is no indication how the original plan might morph as it makes its way through the legislature. The key idea that’s relevant here is that the bigger your taxable income (“adjusted gross income” or AGI), the higher your marginal tax rate. The lowest possible level 10% and the highest is 39.6%.
Why do we care about tax brackets in the context of Social Security? Because sometimes, the taxable portion of your Social Security income can push you into a higher tax bracket. That means that you will be paying taxes at a higher rate than you are used to.
Bottom Line: Taxes and Social Security
Why did I make you read through this complex math? Because I believe that forewarned equals forearmed.
Even if you don’t want to go through the detailed calculations, here are three key points for you to take away from this article.
Remember that a portion of your Social Security benefits is likely to be taxable. Don’t fall for the idea that just because you are retired, you don’t have to deal with taxes.
Your decisions during the year can determine how much of your Social Security benefit end up being taxable. Be careful with additional sources of income, such as IRAs – you may not be getting to keep as much of the distribution as you thought.
Finally, your financial plan should have a built-in cushion to ensure that your lifestyle does not use up every income dollar you receive. How much of a cushion do you need? I am glad you asked. The answer depends on your tax rate.
If you are curious about other ways you can get smart about taxes in retirement, read on for Part 2 of this mini-series, Retirement and Taxes: Part 2 (Hidden Opportunities). You may not know this yet, but retirement can actually present some unique opportunities for optimizing your taxes!