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Tax Consequences of Social Security Benefits: When and How Much to Claim

February 14, 2024

Tax Consequences of Social Security Benefits: When and How Much to Claim

 

 Federal income taxes are relatively straightforward for most individuals during their working years when their income primarily comes from a paycheck. However, taxes in retirement can become more complex due to the various sources of income, including Social Security, that retirees often receive. The calculation of your overall income determines the taxable portion of your Social Security benefits. This calculated income, also known as "provisional" or "combined" income, is essentially half of your Social Security benefit plus other income such as retirement plan distributions and interest earned on municipal bonds.

 

Up to a certain threshold of provisional income, your Social Security benefits are not taxable. However, once you exceed that threshold, a graded scale of taxation applies. For single filers with provisional income between $25,000 and $34,000 (or $32,000 to $44,000 for joint filers), up to 50% of their benefits are taxable. If the provisional income is above $34,000 (or $44,000 for joint filers), up to 85% of the benefits become taxable.

 

In some cases, individuals in the 22% federal tax bracket may end up paying a marginal tax rate as high as 40.7% due to additional retirement income causing a larger portion of their Social Security income to be taxable. This can particularly affect those in the 10%, 12%, and 22% federal tax brackets, especially those with above-average Social Security benefits. If you fall into this category, it may be beneficial to work with a tax professional to carefully plan your retirement expenses, income, and tax projections. This can help determine if any additional planning or adjustments are necessary.

 

For example, let's say you and your spouse receive a combined annual Social Security benefit of $72,000, and your only other income is $70,000 from individual retirement accounts (IRAs).

Your provisional income of $106,000 falls just below the 85% cap on the taxability of Social Security. However, if you withdraw an additional $1,000 from your IRA, you would expect to pay $220 more in taxes due to being in the 22% tax bracket. However, since this $1,000 increases your Social Security benefits subject to tax by $850, your tax bill actually increases by $407 (22% of $1,850). At this point, your marginal tax rate is 40.7%, but it eventually goes back down to 22% at higher income levels. If there are steps you can take to minimize the income taxed at this level, they are worth considering.

 

Here are some actions you can take

Plan before reaching age 73 to avoid the high marginal rate situation caused by required minimum distributions (RMDs). Consider converting Traditional IRA assets to a Roth IRA at a relatively low tax rate early in retirement. This can reduce future RMDs that would push you into a higher tax bracket and trigger the 40.7% marginal rate.

 

Maintain financial flexibility to limit your highly taxed income. If you anticipate being subject to high marginal rates, fund additional spending needs with income sources that generate little or no taxable income. This could involve using cash reserves, a Roth account, or selling investments with small gains.

 

If you're approaching the point where the maximum 85% of your Social Security benefits are taxable, consider taking more taxable distributions once you surpass the 85% cap. This would free up cash for the next year, helping you avoid the high marginal rate in that year.

When it comes to taxes, it is often recommended to wait until full retirement age or even later before claiming Social Security. By delaying your benefits, you can minimize the risk of running out of money in your later years and maximize survivor benefits if you are the higher earner. While taxes are an important consideration in retirement planning, they should not be the primary focus. With that in mind, remember that the first 15% of your Social Security income is exempt from federal income taxes, regardless of your circumstances. Don't be swayed into claiming Social Security early just because you may be subject to higher marginal tax rates. Remember, with a little bit of planning, taxes on Social Security benefits can be managed effectively.

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