Taxes You’ll Owe on Social Security Benefits
Don’t be caught by surprise: Make a plan to minimize taxes
If you’ve been saving in a traditional 401(k) or individual retirement account, you know — at least in the back of your head — that withdrawals you make in retirement will be taxed as ordinary income. Same for a pension benefit, if you’re lucky enough to have one.
What fewer people realize is that a portion of their Social Security retirement benefit may also be subject to federal income tax. The Social Security administration estimates about half of the people who receive benefits owe tax, and that number is expected to rise to nearly six in 10 a decade from now. In 2016 — the most recent data available — the IRS collected income tax on $286 billion in Social Security benefits versus just $144 billion in 2006.
From 1940, the first year Social Security paid out benefits, through 1983, Social Security benefits weren’t taxed. As part of the broad reform passed in 1983, a tax was introduced, but only on recipients whose income (including a portion of their Social Security benefit) was above a threshold. At the time, it was anticipated that only 10% of recipients would be hit by the tax.
So how did we get from 10% in 1984 (when the reform went into effect) to an expected 60% in 2030? Well, the same income thresholds that went into effect in 1984 are used today, unadjusted for inflation, so they hit many more people.
Some good news is that even if you fall into the tax-paying group of Social Security beneficiaries, not every penny of your benefit becomes taxable. No one has to pay federal income tax on more than 85% of their benefit.
Social Security benefit: The tax calculation
Calculating your tax isn’t simple, but it’s an essential step in retirement planning. The first step is to calculate your combined income. Haven’t heard of combined income? Welcome to Social Security world. This is the sum of your adjusted gross income from your federal tax return, plus any interest income from tax-free investments and 50% of your Social Security retirement benefits for the tax year.
Once you know your combined income, you can figure out if your Social Security benefit will be taxed. Here are the categories you could fall into:
No income tax to pay on your Social Security benefit: If you are single and your combined income is below $25,000, or you are married, file a joint tax return and your combined income is below $32,000. (For the record, if those levels had been indexed to inflation, the thresholds in 2019 would be closer to $63,000 for individuals and $81,000 for married couples.)
Income tax to pay on up to 50% of your benefit: If you are single and your combined income is between $25,000 and $34,000, or if you are married and your combined income is between $32,000 and $44,000.
Income tax to pay on up to 85% of your benefit: If you are single and your combined income is above $34,000, or you are married with combined income above $44,000.
If you plan on retiring in Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont or West Virginia, you may also owe state income tax on a portion of your benefit.
Anyone who expects that a portion of their Social Security benefit will be taxable has extra incentive to manage their overall tax bill in retirement. Given the low thresholds for Social Security taxation, the goal isn’t to try to shimmy below that line. That might not be practical. Rather, you might consider broader strategies that can keep your overall taxable income lower.
If you are still saving for retirement, a late-career move is to switch your new contributions from a traditional 401(k)/IRA to a Roth 401(k) or a Roth IRA.
There is no upfront tax break on money you contribute to a Roth, but your withdrawals in retirement are tax-free. That means it doesn’t get counted as part of your adjusted gross income.
Not all 401(k) plans offer a Roth option, but most do now. If your plan has a Roth, all you need to do is tell your plan that you want your new contributions to be saved in the Roth option. (A side note: Some plans will also let you move money from your traditional 401(k) into the Roth. Be careful. There is a tax bill due when you make this conversion that can send your income tax bill soaring. Consulting a tax pro is highly recommended.)
If you don’t have a Roth option at work, or don’t have a retirement plan at work, a Roth IRA is a way to create tax-free income in retirement. Individuals with modified adjusted gross income below $124,000 and married couples that file a joint return with less than $196,000 can contribute $6,000 to a Roth IRA in 2020; if you are at least 50 that limit rises to $7,000.