Springtime always leads to lots of tax questions. Just ask your friendly, neighborhood tax accountant… Our practice is the same since so many retirement planning decisions have a tax ramification. In the past month or so we have gotten a few questions on taxes related to Social Security so I thought we could cover them in one generalized post.
First of all, Social Security benefits are sometimes taxed as income. It all depends on your total income situation during the years you are receiving these SS benefits.
Payroll Taxes Paid Into SS
The other part to the taxation story and Social Security involves the payroll taxes paid INTO the Social Security system in order for someone to become eligible for SS benefits. Most of us realize that SS taxes are paid via withholding from our paycheck by our employer. You and your employer each pay 6.2% of your wages into the SS system, unless you are self-employed and then you pay both since you are seen as both the employer and employee.
Earned Wages But Choose To Not Receive Them Now
But what happens when you have earned wages, but you choose not to receive them now? This is the case if you participate in a 401(k), 457, TSP, etc. or in an IRA. The money that goes into these accounts are wages you have earned, but you are choosing to delay receiving them until sometime in the future. For that reason the money in these accounts is not generally taxed going in, but when you withdraw it in the future you recognize the income and pay the tax. But here we are talking only about INCOME taxes, not payroll taxes like those for Social Security. Even if you are directing money into a 401(k) or IRA and avoiding a current income tax burden, you always pay the Social Security taxes the year you earned these wages.
Not Subject to Social Security Withholding
Because of this tax treatment you are not subject to Social Security withholding taxes when you take the money out of your 401(k) or IRA. The only taxes still left to be paid are INCOME taxes. None of the money in your 401(k) nor your IRA is subject to Social Security taxes since they are not considered WAGES when distributed. They are considered INCOME so you recognize these distributions on your 1040 tax form, but only WAGES and self-employment income are subject to SS taxes.
On a related note, income from interest, dividends, annuity payments, pension funds, rental property, etc. is not treated as wage income subject to SS taxes, except in really rare situations that are beyond the scope of this article. For this reason you will not see SS tax withholding on your statements from your IRA and brokerage account custodians, insurance companies, nor pension and 401(k) administrators.
Taxes are an important item to monitor and plan for in retirement, but luckily once we stop working for wages we can stop worrying about Social Security payroll taxes. At least for now…