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There has been a lot of talk around the office and with clients about taxation of Social Security benefits. Since we are talking about taxation, we are talking about Internal Revenue Code (IRC), and we all know that the IRS likes to make things a clear cut as possible**[1]. In this week’s news article I attempt to break the concept down for one main reason; taxation of Social Security is overly complicated but it’s very important that retirees have a minimum knowledge of it so they can understand some advanced tax and financial planning strategies that revolve around Social Security taxation.
The Summary
Up to 85% of Social Security is taxable. Keyword “taxable”; the amount of your Social Security that will be included as income which will then be taxed at your applicable tax rate. Something to understand here is even if someone’s taxable Social Security is at the maximum of 85%, Social Security income still has tax preference because the remainder 15% is not taxed at all.
There are thresholds that the IRS has set that phases in how taxable Social Security is:
If Provisional Income (defined below) is less than the first threshold Social Security is not taxed at all.
If Provisional Income is less than the second threshold 50% of Social Security could be taxable.
If Provisional Income is greater than the second threshold 85% of Social Security could be taxable.
Of course, finding out how much Social Security is taxable is made easy with a short 18 step form provided by the IRS**. If you took the time and went line by line on the form you would likely come up with the correct taxable amount, but you was also have no idea as to why that figure is correct (and if you don’t know why its correct, you don’t know how you can strategize around it!)
The Calculation
This is my attempt to break down the 18 steps into a few concepts to help you understand how taxable Social Security is really calculated. I warn you, this reading gets a little technical!
First, “Provisional Income” must be determined. This is fairly easy and can be done by adding up the following:
Half of the Social Security benefits received
All other taxable income (i.e. pension, wages, annuity, IRA[2] and 401k distributions, etc.)
All tax exempt interest (i.e. municipal bond interest) and other excluded income.
For example, if George received $20,000 in Social Security benefits, withdrew $21,000 from his traditional IRA, and received interest of $1,000 from a municipal bond holding, he would have provisional income of $32,000 ($10,000 + $21,000 + $1,000)
Second, a comparison needs to be made between Provision Income, the “Base Amount” and the “Adjusted Base Amount.” This comparison will then guide you on how the calculation is made. Things start getting a little wonky here, but below you find it explained in the most comprehendible manner that I could come up with. Let’s start with some figures on what the Base Amounts and Adjusted Base Amounts are and then we can apply some concepts on what they represent.Filing StatusBase AmountAdjusted Base AmountSingle $ 25,000 $ 34,000Married Filing Jointly $ 32,000 $ 44,000Married Filing Separately (lived apart) $ 25,000 $ 34,000Married Filing Separately (lived together) $ 0 $ 0
How It Basically Works
Provisional Income Less Than Base Amount
If provisional income is less than the Base Amount then no Social Security benefits are taxable.
This is fairly simple to understand. If half of your Social Security plus all of your other income is less than the Base amount that corresponds with your filing status then you won’t owe any taxes on your Social Security.
Provisional Income Between Base Amount and Adjusted Base Amount
If provisional income is between the Base Amount and the Adjusted Base Amount then 50% of the Provisional Income that is in excess of the Base amount is taxable and this amount cannot exceed 50% of the Social Security benefits received. For example:
If George – a single taxpayer – had $32,000 of provisional income then he would be above his Base Amount by $7,000 ($32,000-$25,000) but less than his Adjusted Base Amount.
If his Social Security benefit was $20,000 (as we talked about earlier) then no more than $10,000 (half of the $20k benefit) could be taxable.
Since 50% of the excess provisional income over the base amount ($3,500 – Half of $7,000) is less than $10,000 he would have to include $3,500 of his Social Security benefits as taxable income. Had half of the excess provisional income been greater than $10,000 the taxable Social Security would have been capped at $10,000.
Provisional Income Greater Than Adjusted Base Amount
If provisional income is greater than the Adjusted Base Amount – well… things get ugly. Just remember the highest percentage of Social Security benefits that are taxable is 85%. If you want to understand the nitty gritty then read the example below:
Assume George – our single taxpayer – still has the same Social Security benefit but now has $62,000 of provisional income (maybe he took an extra $30,000 out of his IRA to buy a new car).
First, we need to find out 50% of the difference between the Adjusted Base Amount and the Base amount. In his case this figure is $4,500 (50% of $34k minus $25k).
Second, we need to find out what 85% of the amount of excess provisional income is over the Adjusted Base Amount. In his case this figure is $23,800 (85% of $62k minus $34k).
Third, we need to add these figures together to get a tentative taxable amount and see if it is greater than 85% of his Social Security benefits. Tentative taxable amount is $4,500 + $23,800 = $28,300. 85% of his Social Security benefits is $17,000 (85% of$ 20k), so he would have to include $17,000 of his Social Security benefits as taxable income. If his tentative taxable amount was less than $17,000 then he would have been able to use the lesser amount.
Congratulations on making it through the convoluted path of Social Security taxation. It took me many times to make sense of it all so if the concepts are still unclear you are not alone. However, if you are interested in learning more about this or wondering how you can optimize the taxation of your Social Security benefits please feel free to contact us.
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[1] ** Indicates attempts at overt sarcasm.
[2] Note that ROTH distributions are generally excluded from this.
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