Taxing Your Social Security Benefits
Thousands and thousands of Americans got to experience what it feels like to be on the ‘other side of the fence’ for the first time over the last twelve months.
The other side of the fence I’m referring to is collecting social security income instead of paying into it!
It doesn’t matter how much money you have, or what your expectation levels have been. Getting that first check from Social Security always feels pretty good.
You’re finally getting to reap the benefits of all that money you gave up throughout your working life. Although it’s not much, it still represents a small “payback” for all of the years you paid into the system.
However, that small sense of euphoria came to a screeching halt for thousands of people when they went to pick up their 2011 income tax returns from their accountant.
Depending on how well you planned, picking up your income tax return from your accountant each year can either be a pleasant experience or a day set aside each year for massive amounts of anxiety.
For far too many people, there was a big surprise waiting for them this year. And, that surprise was finding out that they had to pay a large chunk of money in taxes when they mailed in their return.
They didn’t know that their new social security benefits are subject to income tax along with the rest of their other income!
I can just hear the irritation in their voice as they say to their accountant, “we have to pay income taxes on our social security benefits? Didn’t we pay taxes our whole life to social security? Now we pay taxes again to get the money out?”
The short answer is yes, in most cases. In fact, it got even worse back in the mid 1990’s. It used to be that only 50% of your benefits were subject to income tax.
Now, as much as 85% of your benefits can be taxed! (a 70% increase!)
How The IRS Taxes Your Social Security
Let’s take a look at the “rules” that apply when taxing your social security benefits. (Yes, more rules to follow!)
The tax on your social security benefits depends on the amount of “other” income you have (known as “provisional” income).
Provisional income is your adjusted gross income without social security, and tax-exempt income from municipal bonds, plus one-half of your annual social security benefits.
As a married couple, as long as your “other” (provisional) income is less than $32,000, there is no tax on your social security benefits ($25,000 for individuals).
If your “provisional” income is between $32,000 and $44,000, up to 50% of your social security benefits are taxable.
And, once your provisional income reaches $44,000, up to 85% of your benefits are subject to taxes.
Now, to be clear, this doesn’t mean that you pay 85% tax on our benefits. It means that 85% of your benefits are “subject to tax”.
So, for example, if you’re married and your combined social security benefits total $2,500 per month, or $30,000 per year, and your “provisional” income is $44,001, 85% of your social security benefits ($25,500) will be subject to federal income taxes.
If you’re in the 25% marginal tax bracket, you have the honor of giving back $6,375 in taxes on your benefits to the federal government!
Imagine that! You’ve worked and paid into the system your entire life and now you have to “GIVE BACK” over $6,000 per year in taxes on the $30,000 per year in benefits you receive!
I know what you’re thinking: “who came up with this one?”
Is There A Way Around This?
Depending on the “sources” of your provisional income, you may or may not be able to do something about this.
So, for starters, if you have “provisional” income locked in place above the $44,000 threshold (like a fixed monthly pension), there is not much that you can do to prevent this. 85% of your social security benefits will be taxable.
However, if your “other” income comes from various sources such as interest, dividends, capital gains, and IRA withdrawals, there’s a lot you can do with proper planning.
And, it has a double effect. Not only can you reduce your taxes on your social security benefits, but also on all your other income at the same time.
In a future blog, we’re going to explore methods to do just that.