Taxes on Social Security


Many retirees depend on Social Security benefits or other government-sponsored retirement benefits as a primary source of retirement funds. Knowing if and how your benefits may be taxed will help you plan your retirement budget. 
 

How Social Security Benefits Are Taxed

A three-level system based on your modified adjusted gross income (MAGI) is used.

What's your MAGI? Your adjusted gross income (AGI) is all of your income, such as wages, salary, and interest you get from bank accounts, minus certain deductions, like contributions you make to a retirement account. Your MAGI is your AGI:
  • Minus various other deductions, like student loan interest and some tuition expenses
  • Plus any foreign earned income exclusion, which might apply if you live in and earn income in another country, and tax exempt interest, which usually is interest you get on state or local government bonds

The Three Levels

Low income taxpayers. If your MAGI plus half of your benefits are below a certain base amount, you don't have to report any of your Social Security or Tier 1 benefits. For married taxpayers filing jointly, the base amount is $32,000. For married couples who live together and file separately, the base amount is $0. For all other taxpayers it is $25,000.

For example, you're 67 years old and received $10,000 of Social Security benefits in 2010. You also earned $12,000 from a part-time job, and you have $3,000 of taxable interest and $2,500 of tax-exempt interest. Here, your MAGI is $17,500 ($12,000 + $3,000 + $2,500). None of your benefits are taxable because your MAGI plus half of your Social Security benefits ($22,500) is less than $25,000.

Middle income taxpayers. If you're in this level, you may have to include up to 50 percent of your benefits in gross income. If your MAGI plus half of your benefits is more than the base amount, you have to report the lesser of:
  • 50 percent of the benefits you received, or
  • 50 percent of the excess of MAGI plus 50 percent of Social Security benefits over the base amount
In other words, each additional dollar of provisional income causes another 50 cents of Social Security benefits to be taxed until 50% of all benefits are taxed. So, receiving an extra $1 of income can cause you to owe tax on $1.50 of income.

High income taxpayers. Here you may have to report up to 85 percent of your benefits as gross income. If your MAGI plus half of your benefits go above an adjusted base amount, you have to report the lesser of:
  • 85 percent of the benefits received, or
  • The sum of: (1) 85 percent x (MAGI + one-half of your benefits) minus the elevated base amount, plus (2) the lesser of (a) the amounts calculated by a "middle income taxpayer" or (b) $9,000, or $12,000 if you file jointly, for 2010
In other words, each additional dollar of provisional income causes another 85 cents of Social Security benefits to be taxed until 85% of all benefits are taxed. So, receiving an extra $1 of income causes you to owe tax on $1.85 of income.


In summary, there are three adjusted base amounts:
  • $44,000 for married taxpayers filing jointly
  • $0 for married couples who live together but file separately
  • $34,000 for all other taxpayers
 

Example: You file a single tax return, have taxable income of $34,000 from a pension and IRA accounts, and receive Social Security benefits.

Normally, $34,000 of taxable income would place you in the 25% tax bracket. But in this income range, increasing income by $1,000 -- perhaps by taking $1,000 from a traditional IRA to meet a financial need -- increases the amount of your Social Security benefits that are taxable by $850. So, you owe 25% tax on $1,850, causing $462.50 of tax to be due. This $462.50 of extra tax resulting from $1,000 of additional income is a 46.25% marginal tax rate.

What to do: Use tax software to run the numbers, or have a tax adviser do it for you.
If it will, be sure to pay enough income tax through estimated or withheld taxes to avoid underpayment penalties.
If you’re about to retire, consider delaying first taking Social Security benefits until age 70  to avoid this "boosted" tax rate during the years you’re not taking the benefit. When you delay taking benefits, you’ll receive correspondingly increased benefits later.
Take tax-free distributions from Roth IRAs instead of taxable distributions from traditional IRAs while in the "boosted tax rate" zone.