The ins and outs of Social Security benefits and taxes

Beneficiaries with income above those levels pay taxes on up to 85% of benefits.

Michael Kitces, director of research for Maryland-based Pinnacle Advisory Group, offers this example:

Jeremy and Martha have an AGI of $28,000 (and no tax-exempt or foreign income), and receive combined Social Security benefits of $14,000. As a result, their provisional income is $28,000 + $7,000 (half of Social Security benefits) = $35,000, which is $3,000 above the $32,000 threshold. This means that 50% x $3,000 = $1,500 of their Social Security benefits are subject to taxation, which ultimately increases their AGI to $28,000 + $1,500 = $29,500.

Beneficiaries receive IRS Form SSA-1099 from the IRS during tax season, which reports your net benefit subject to tax (after Part B Medicare premiums have been subtracted).

Income is reported on the 1040 or 1040a forms (Form 1040EZ cannot be used). The popular tax-filing software programs also have the capacity to handle Social Security income. You can also ask the Social Security Administration to withhold taxes when you file for benefits at rates of 7%, 10%, 15% or 25%. “It’s just a matter of convenience–not a requirement,” says Greg Rosica, a tax partner at Ernst & Young and contributing author to the EY Tax Guide 2016.

State policy on taxation of benefits varies. Twenty-nine states (including the District of Columbia) that have a broad-based income tax exempt all Social Security from tax, according to a tally by the Institute on Taxation and Economic Policy. Seven states tax some Social Security benefits but provide an exemption that is more generous than what is available at the federal level. Six states tax Social Security benefits using the federal formula.

The Earnings Test

One point of confusion about taxes and Social Security swirls around the earnings test. This is the formula that withholds benefits for people who have claimed benefits below their full retirement age (FRA) and still earn income from work. Although some people think of the earning test as a tax, the withheld amounts actually are added back into your benefit after you reach FRA.

In these cases, Social Security withholds one dollar in benefits for every two dollars of earnings in excess of an exempt amount of income. For workers who reach FRA after 2016, the exempt amount is $15,720. For workers who reach FRA in 2016, the annual exempt amount is $41,880–a limit that applies only to earnings made in months prior to the month of NRA (normal retirement age) attainment. For that higher limit, one dollar of every three dollars in benefit is withheld.
After FRA, Social Security recalculates your benefit to give credit for the withheld payments. The payments are added back in during the year after a beneficiary reaches FRA, according to the Social Security Administration.
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