While recent news has focused primarily on the long-term projections for the financial viability of the Social Security system, Americans who are currently receiving benefits or considering claiming their benefits should understand how their payments are taxed and what effect their other income sources can have on this taxation.  According to the Social Security Administration (SSA), roughly 40% of recipients are required to pay federal income tax on at least a portion of their benefits.  The United States government has been taxing Social Security benefits since 1984, and 1993 saw the introduction of the higher “tax bracket”, an income level at which up to 85% of Social Security benefits would be federally taxed.

The first step to determine how you will be taxed on your Social Security benefit payments is calculating your “combined income” for the year.  This figure is found by taking your adjusted gross income (AGI) and adding non-taxable interest (such as municipal bond income) and half of your total Social Security benefit amount listed on the form SSA-1099 that you receive each January.  Second, you should compare this income number with the IRS base limits, which tell you what range of incomes are subjected to taxation of benefits.  For 2019, married couples filing jointly will owe income tax on up to 50% of their Social Security benefits if their combined income falls between $32,000 and $44,000.  Once combined income reaches $44,000, up to 85% of the benefit amount may be taxable.  For single filers, the 50% taxable range extends from $25,000 to $34,000.  The actual taxed percentage depends on the amount by which your combined income exceeds the income threshold.  Once you determine the taxable portion of your benefits, the regular federal income tax tables are applied to your AGI plus the taxable portion of your Social Security payments.  Keep in mind that 15% of your Social Security benefits cannot be federally taxed, regardless of income.

The above taxation structure is solely applied at the federal level.  Each state taxes retirement benefits (pensions, IRA distributions, Social Security) differently and a majority do not tax these amounts at all.  For instance, states such as Illinois, California, Florida, Texas, Washington, and Wisconsin do not levy a tax on Social Security benefits.  The handful that do tax Social Security at the state level include Colorado, Kansas, Minnesota, Missouri, Utah, and a few others.  Determining your legal state of residence is outside the scope of this article, but it is important to be aware of both state and federal taxation rules, especially if you do not reside in the same state year-round.

Federal taxation of Social Security benefits highlights the importance of being able to manage your taxable income in retirement.  If all of your retirement savings are held in pre-tax accounts like a 401(k) or traditional IRA, your fully-taxable required minimum distributions (RMDs) beginning after age 70.5 will most likely push your annual income into the 85% taxable range for Social Security benefits.  If, however, you made Roth conversions during some low income years before drawing Social Security benefits or contributed directly to a Roth IRA or Roth 401(k), you can maintain flexibility with your taxable income, potentially dropping the percentage of taxable benefits to 50% or even 0%.  This is because your annual RMDs will be reduced and any distributions from Roth accounts to cover retirement expenses do not have an effect on the combined income calculation described above.  The availability of annual Roth conversions to convert some of your pre-tax retirement savings between your retirement date and claiming Social Security benefits serves as another argument in favor of waiting to delay claiming benefits until age 70, when the maximum delayed benefit credit is achieved.  Another strategy to minimize the RMD figure is to fund your post-retirement, pre-Social Security expenses with pre-tax funds saved in a traditional IRA or 401(k).  You will have to pay income tax in the year the money is withdrawn but might be able to reduce your future RMD amount enough to avoid paying taxes on a larger portion of your Social Security income down the road.

If you do find yourself required to pay income taxes on your Social Security benefits, you may either make quarterly estimated tax payments to the IRS or have federal taxes withheld from your Social Security payments.  The SSA gives you the option to choose between multiple levels of withholding, ranging from 7% to 22%.  At any time, you may switch between the two methods by either notifying the SSA to cease tax withholding from your benefits or filing Form W-4V (voluntary withholding) with the SSA to begin having taxes withheld.

The tax landscape is constantly changing, and it is important to understand how each dollar of your income is taxed by Uncle Sam and your state.  Contact a financial planner at Moller Financial Services if you would like to discuss your tax situation and planning in more detail.