taxes
September 2, 2015 | by Chris Stein, CFP®, Finance Instructor at Colorado State University
Taxes On Lump-Sum Social Security Benefits

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Sometimes Social Security benefits are paid in one lump sum, with two examples being Retroactive Benefits and Suspended Benefits.  We recently had a reader contact us asking how the taxes are calculated on these lump-sum benefits.  Let me first set the stage with the basic issues at hand:

Retroactive Benefits

  1. Retroactive Benefits are those benefits to which you are entitled between your Full Retirement Age and your actual filing date, with a 6 month maximum.  Essentially these benefits are available to you as a lump sum if you file for SS after your FRA and you would like to “back date” your application and collect the benefits you would have received had you filed earlier.  These benefits come to you as a lump-sum amount and are limited to a maximum of 6 months.

Suspended Benefits

  1. Suspended Benefits are those benefits that SS has been holding for you after you have requested they suspend your payments. You are allowed to do this after reaching your FRA regardless of when you originally filed for benefits.  These suspended benefits can accrue from as early as your FRA all the way until age 70 when your benefits will resume.  Up until reaching age 70 you have the option of asking for all these suspended benefits in one lump sum instead of taking advantage of Delayed Retirement Credits that you would accrue if you let SS keep the suspended benefits.  Unlike Retroactive Benefits, which are limited to 6 months of monthly benefits, there is no limit to claiming Suspended Benefits, although there is a practical limit of 4 years for people having a FRA of age 66 (70 minus 66 is 4 years).

Tax Bump

  1. If you claim either of the lump-sum benefits above, or even other lump-sum benefits I have not listed, they will come to you all in one tax year. This could generate a large “bump” in your income for that year and possibly lead to an unfavorable tax situation (read:  high taxes).  In reality this lump sum is made up of benefits owed to you over several months or even years in the case of suspended benefits.

So the reader is right to be concerned.  What if they see a move in their marginal tax bracket as a result of this one-time, lump-sum payment?  How is that fair?  The good news is that the IRS has a way to help with this issue.  The following is explained in detail in IRS Publication 915 “Social Security and Equivalent Railroad Retirement Benefits” (see page 11).

Special Rules for Lump-Sum Benefit Payments

Basically the IRS allows you, through the use of several worksheets, to apply the portion of the lump-sum benefits that was technically for a prior year, to be treated for tax purposes similar to if you had received them those prior years.  This has the effect of spreading out the “income” from SS benefits into the years where it would have occurred had you been receiving it monthly instead of in one lump sum.  When you receive the lump-sum benefits you will also receive a form SSA-1099 describing the benefits you were actually paid that year.  On that form will appear an explanation of which years those benefits were actually intended to be paid.  With this information you can make the adjustments to avoid a tax nightmare that may occur as a result of recognizing all that income in a single year.  All this WITHOUT filing amended tax returns for those prior years.  Not having to file amended returns for prior years is a HUGE benefit to this IRS procedure.  Publication 915 takes what would otherwise be a taxpayer nightmare, or maybe a CPA’s dream, and turns it into a fairly straightforward adjustment.

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