The federal tax rules for Social Security benefits haven’t changed in many years. They remain complicated and snare more retirees each year.
A number of my readers are old enough to remember when Social Security retirement benefits were tax free on their federal income tax returns. That ended in the 1980s, and taxes on the benefits of higher-income taxpayers were increased in 1993.
Since then, your income level determines if and how much of your benefits are taxed. A special computation of income is required to determine the amount of your Social Security benefits that are taxable, and it is fairly complicated, even for the tax code.
You probably want to use software or a tax preparer to ready your income tax return if your Social Security benefits might be taxable. First, there’s a quick calculation to determine if any of your benefits might be taxable.
Start with gross income on your income tax return. Add to it one-half your Social Security benefits and tax-exempt interest. Also add any exclusions from income such as foreign earned income and housing allowances. None of your Social Security income should be taxable if this total doesn’t exceed what the IRS calls the base amount. For married couples filing jointly, the base amount is $32,000. For married couples filing separately who live together at any time during the year, the base amount is $0. For all other taxpayers, the base amount is $25,000.
It is important to note that these amounts have been fixed since 1986. Since they haven’t been indexed for inflation, the percentage of Social Security recipients who pay income taxes on their benefits increases simply because of inflation.
Once your income is in the range where benefits might be taxed, a special definition of income is used to determine how much of your Social Security benefits are taxed. It is usually known as either modified adjusted gross income (MAGI) or provisional income.
You start with gross income as reported on your tax return. You add one-half of your Social Security benefits. Then, you add a number of tax breaks that were excluded from gross income. These include tax-exempt interest, foreign earned income and housing allowances, adoption benefits and some less common benefits. You can subtract any deductions you have for adjusted gross income, such as one-half of self-employment taxes, health savings account contributions, and others.
The final number is the income used to determine the portion of your benefits that are included in gross income. You can see that a number of strategies that reduce regular income taxes, such as investing in tax-exempt bonds, don’t reduce taxes on Social Security benefits.
Also, none of your itemized deductions reduce taxes on the benefits.
For married couples filing jointly, when the MAGI total is between $32,000 and $44,000, then up to 50% of the benefits will be included in gross income. For other taxpayers, up to 50% of the benefits will be included in gross income when income is between $25,000 and $34,000.
Up to 85% of benefits will be taxable when the income for married couples filing jointly exceeds $44,000 or it exceeds $34,000 for other taxpayers.
Because of this tax, Social Security beneficiaries can face some of the highest marginal tax rates among taxpayers. The marginal tax rate is the tax rate on your last dollar of income. For most taxpayers, the marginal tax rate is the same as the rate for their tax bracket. But other taxpayers face what I call the Stealth Taxes. They have tax breaks that phase out as income rises. For them, the marginal tax rate is higher.
The taxation of Social Security benefits is a Stealth Tax because the higher your income rises, the more of your benefits are taxed. Once income is in the range in which benefits are included in gross income, each dollar of additional income means not only is that dollar included in gross income, so is an additional amount of Social Security benefits.
The result is that Social Security beneficiaries can be in marginal tax brackets of 70% and higher, especially when the state taxes the benefits. Even someone whose regular marginal tax rate is less than 20% can face a marginal tax rate of over 40% when Social Security benefits become taxable. Also, check how your state treats Social Security retirement benefits. Most still exempt them, but a few states tax some or all of the benefits.
Married couples should know the tax is triggered based on the joint income of the couple. So, you don’t delay or avoid taxes on benefits when only one spouse is receiving benefits and that spouse’s income is below the threshold. Choosing the married filing separately status makes things worse, because benefits are taxed when income exceeds $0.
There are some strategies that can reduce or delay the taxation of Social Security retirement benefits. Manage retirement plan distributions. You don’t have control over required minimum distributions from qualified retirement plans, such as IRAs, and some distributions from annuities and pensions.
But you do have discretion over additional distributions from IRAs and perhaps other accounts. When you have an additional spending need, carefully consider the tax consequences before deciding the source of the funds. Taking an additional distribution from a traditional IRA not only is taxable but also could cause more of your benefits to be taxed.
You might be better off taking money from cash accounts or some other source that won’t increase gross income.
Roth IRA distributions aren’t included in gross income either for regular income tax purposes or for calculating the tax on Social Security benefits.
You can reduce future taxes on Social Security benefits by converting all or part of your traditional IRAs to Roth IRAs. It is ideal to do a conversion before receiving Social Security benefits. If you do a conversion while receiving benefits, the change likely will increase the taxes on benefits in the year of the conversion. Over the long term, however, it still could save enough taxes to make it worth doing.
Manage Taxable Investment Accounts.
Transactions in your taxable investment accounts affect gross income, so they can affect how much of your benefits are taxable.
Taking capital gains increases your income and therefore the amount of your benefits that are taxed. It is best to monitor your gross income during the year. Before selling appreciated investments, consider how the sale might affect taxes on your benefits. You might want to delay some gains until next year or recognize some losses in your portfolio to offset the gains.
On the other hand, if the maximum amount of benefits already will be taxed, you might want to take some gains you may have left for next year. That could decrease the amount of benefits that will be taxed next year.
Mutual funds also might make significant year-end distributions that increase your taxable benefits. Some people find it helpful to switch from actively managed funds to index funds or to actively managed funds that historically have low distributions.
Others contact the funds for estimates of their late-year distributions and plan to take some capital losses or make other adjustments in years when fund distributions will be high.
Some people put a portion of their investment money into tax-deferred annuities, either fixed or variable. The annuities don’t have required distributions, and all income and gains aren’t taxed as long as they stay in the annuities. After other assets are spent down, you can begin tapping the annuities, or they can be left to your heirs.
Plan With Family Members.
It might be better to give to family members now rather than later. Give family members property that generates income or that you’re planning to sell. The family members might be in lower tax brackets, reducing the family’s tax burden.
Of course, only give property that won’t reduce your standard of living. The tax on Social Security benefits is another reason to consider giving property during your lifetime. See our August 2018 and January 2019 issues for details.
Remember that tax-exempt interest is included in income when calculating the tax on Social Security benefits. But tax-exempt bonds and mutual funds have lower yields than taxable bonds and mutual funds. So, the amount of money included in gross income will be less when you own tax-exempt bonds instead of taxable bonds. That could reduce the taxes on your benefits without reducing your after-tax income.
Losses from businesses, including part-time businesses, can reduce gross income for both regular income tax purposes and for determining the amount of Social Security benefits that are taxed.
You might find it beneficial to turn a hobby into a business that generates a tax loss. The losses can be deductible if you make a profit in at least three out of any five consecutive years. Or you can never earn a profit and still deduct the losses if you are running the activity in a professional manner with the intention of making a profit.
The tax rules on deducting business losses are tricky. Consult with a tax advisor before deciding to pursue this strategy.