It’s an unpleasant fact of life: The taxman can take a bite out of your Social Security benefits.
The federal tax formula was crafted to initially target higher-income households, but the share of benefits taxed has risen over the years, because the income thresholds for taxation aren’t indexed for inflation or real income growth. Meanwhile, there are big variations in how states tax benefits. As a result, a solid retirement plan should include an understanding of whether you will pay taxes on Social Security benefits, how much you’ll pay, and how that will impact your overall tax picture in retirement. In some cases, savvy planning can lessen the tax bite.
Why Benefits Are Taxed
Benefits were first taxed in 1984 as part of a comprehensive Social Security reform package signed into law the previous year aimed at stabilizing the program’s finances. The most important part of that reform was the gradual lifting of retirement ages, but taxes collected on benefits played a supporting role. Taxes on benefits go to the Social Security Trust Fund and contribute to its solvency. Taxation of benefits for higher-income households was expanded in 1994, with the additional revenue dedicated to shoring up Medicare. Taken together, $51 billion in tax receipts went to the trust funds of the two programs in 2014, according to the Congressional Budget Office (CBO).
About half of all Social Security beneficiaries owed some amount of income tax on their benefits in 2014, according to the CBO, but the burden falls mainly on higher-income households. Beneficiaries with incomes below $40,000 owed less than 0.5% of benefits in taxes in 2014, while those earning more than $100,000 owed 21%.
However, the CBO estimates that taxes paid will rise from 6.5% of total benefits in 2014 to more than 8% by 2024, and more than 9% by 2039. That is due to the lack of indexation of the income thresholds.
The formula’s targeting of higher-income households makes it the opposite of the payroll tax, which is paid by workers and employers alike at a flat rate of 6.2% of wages up to $118,500. “The payroll tax is regressive, but the benefit tax is progressive,” says Andy Landis, a retirement educator and author of Social Security, The Inside Story.
How Benefits Are Taxed
The formula used to determine the tax is unique. First, you determine a figure Social Security calls “combined income” (also sometimes called “provisional income”). This is equal to your adjusted gross income plus nontaxable interest plus 50% of your Social Security.
No taxes are paid by beneficiaries with combined income equal to or below $25,000 for single filers and $32,000 for married filers. (If that sounds like a marriage penalty, that’s because it is one. On the other hand, married couples can access valuable spousal and survivor benefits not available to single people. So, let’s call that one a wash.)
Beneficiaries in the next tier of income–$34,000 for single filers and $44,000 for married filers–pay taxes on up to 50% of their benefits.
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