Social Security income is an important piece of nearly every retirement plan. But what many don’t realize, is that your Social Security income may be taxable income to you upon receipt.
How much of your Social Security is taxed is subject to a number of different factors.
Paying Into the System
Just like the rest of you, I don’t like to pay taxes. However, just like the rest of you, I do pay them.
I pay them because, well, I don’t have a choice. Even so, I do like to think that my taxes go towards a greater good.
That greater good comes in many ways. One of the greater goods funded via my and your tax dollars is the Social Security system. This is a system that pays retirees and others an income backed by the full faith and credit of the good ol’ US Government. Now, while you and I can argue about how good or not good the Social Security system may be, we can all agree that it’s probably not perfect. That being said, it’s our not perfect system, which is why I truly love Social Security.
So, how much do we pay into the system? During our working years, one could argue that we pay a lot. In fact, 7.65% of our gross wages goes to fund Social Security and Medicare (specifically, 6.2% allocated for Social Security and 1.45% for Medicare). For example, if you make $100,000, then you pay $7,650 for this payroll tax.
The good news is that Social Security has a limit on how much you pay into the system. Once your wages exceed $118,500 (in 2015), you no longer pay the 6.2% in Social Security tax. You do, however, continue the pay the Medicare tax.
So why does this matter?
In one sense, it doesn’t matter at all. It’s a tax, and we have no choice but to pay that tax.
In another sense, it does matter. We pay tax into a system that promises to provide future income benefits in retirement. We fund the Social Security system with our tax dollars, but when we receive Social Security income later, the IRS taxes us again!
How much tax do we pay on our Social Security benefit? That depends.
It depends on a number of things, including your total Social Security income, your other wages, and your other income sources.
The Good News
Regardless of your taxable income, the maximum amount of Social Security that can be taxable is 85%. This means that at least 15% of your Social Security benefit is tax-free. For example, if your Social Security benefit is $24,000 per year, at least $3,600 will be tax-free.
To understand just how much above this 85% of your Social Security could be taxable, we need to dig in a little deeper. The amount that is taxable is directly related to how much taxable income you have.
Taxability is Based on Your Combined Income
The amount of Social Security that is taxed is based on your “combined income”. Combined income is calculated by adding the following figures:
- Your Adjusted Gross Income
- PLUS your non-taxable interest
- PLUS ½ of your Social Security Benefit
Your Filing Status Matters Too
Once we have established your combined income, we can determine how much of your Social Security benefit will be taxable. The rules regarding the taxable amount are dependent on your filing status. Two of the more common filing statuses are “Individual” and “Married Filing Jointly”.
For either filing status, the amount of your Social Security that is taxable will be 0%, 50%, or 85% (this is not the amount of tax you will pay; this is the amount that you need to pay tax on!).
For an individual, the key numbers are as follows (for 2015):
- If your “combined income” is less than $25,000, then you will not be taxed on your Social Security
- If your “combined income” is between $25,000 and $34,000, then you may be taxed on up to 50% of your Social Security benefit.
- If your “combined income” is above $34,000, then you may be taxed on up to 85% of your Social Security benefit.
For “Married Filing Jointly”, the key numbers are as follows:
- If your “combined income” is less than $32,000, then you will not be taxed on your Social Security
- If your “combined income” is between $32,000 and $44,000, then you may be taxed on up to 50% of your Social Security benefit.
- If your “combined income” is above $44,000, then you may be taxed on up to 85% of your Social Security benefit.
How to Control your Combined Income in Retirement
When you retire, it’s important to know where your income is going to come from. Often, your income will come from a combination of places, including Social Security, a pension and/or distributions from your investment accounts. How you manage these distributions in retirement is a critical aspect of any sound financial plan.
Above, we see how much income can be withdrawn while continuing to remain in a target range. Therefore, with strategic tax planning, an opportunity may exist in retirement to control just how much Social Security is taxable.
In order to effectively control how much Social Security income is taxable in retirement, it’s important to identify what types of income will increase your combined income. Some of these incomes include:
- Pension Income
- Capital Gain Income (both short term and long term)
- IRA distribution income
- Income from a ROTH conversion
- Income distributions from growth in a non-IRA annuity
- Municipal bond interest
These income sources will increase your adjusted gross income, thereby potentially increasing the amount of your Social Security that is taxable.
In addition to knowing what will increase your combined income, it’s equally important to know what will not. Some of these include:
- ROTH IRA distributions
- The sale of non-IRA assets with no gain or loss
- The return of contributions to a non-IRA annuity
- Distributions from a permanent insurance policy (loan or withdrawal of contributions).
What Does this Look Like in Practice?
In practice, controlling the taxability of Social Security can be difficult. It takes a combination of sound tax planning, investment planning and income planning. It may require delaying the start date of certain income sources and/or reallocating existing investments from mutual funds into something else.
If you’d like to see this in practice, I encourage you to read these articles.
Moreover, while paying less in tax is often a goal, it shouldn’t be the only goal. Controlling your income taxes should be a singular consideration amongst many other factors in a comprehensive retirement plan.