My experience as a volunteer tax preparer tells me that there is a lot of confusion among retirees about how Social Security benefits are taxed. This is a significant topic and not just for tax planning purposes. Taxation of benefits is also important to the threshold decision on when to claim Social Security retirement benefits. So let’s review some basic Social Security vs. income tax concepts.
2. To estimate whether your benefits are taxable, add up all of your adjusted gross income as shown on your tax return plus any tax-exempt interest income. To this total, add 1/2 of your Social Security benefits. If this “combined income” grand total is more than $25,000 for an individual or $32,000 for a married couple, you will owe taxes on your benefits. (If you want to use the official IRS Form 703 to make this calculation, you can find the form here.
3. If the combined income calculation according to paragraph 2 above is between $25,000 and $34,000 for an individual ($32,000 to $44,000 for a married couple), 50% of your Social Security benefits will be taxed as ordinary income
4. If the combined income calculation according to paragraph 2 above is above $34,000 for an individual ($44,000 for a married couple), up to 85% of your Social Security benefits will be taxed as ordinary income. Strangely, no matter how much other income you have, at least 15% of your Social Security benefit is never taxed.
5. If your Social Security benefits are taxable, you may voluntarily request tax withholding from your benefit checks but withholding is not mandatory. Withholding may be a good idea to avoid year end surprises. To make a withholding request, use IRS Form W-4V. You can then to choose to withhold either 7%, 10%, 15% or 25% of your benefit to pay income taxes.
6. Tax calculation example: Assume you are married and filing jointly, receiving $12,000 in Social Security benefits with a “combined income” of $42,000. This combined income exceeds the $32,000 threshold by $10,000. Based on this, the amount of benefits that will be included in your taxable income is $5,000 which is the smaller of half your benefits ($6,000) or half the excess income over the threshold ($5,000). If your marginal rate is 15%, the tax on your Social Security benefits is $750. (This really is quite sad because if you are still working, you are still paying the Social Security payroll tax plus now you are paying a tax on benefits for which you previously (at least theoretically) paid payroll taxes.
7. Some state and local income taxing authorities also will tax Social Security retirement income. The Social Security Administration cannot help you with those numbers nor will it withhold state or local income taxes from your benefits.
8. To minimize the income taxes you will pay on Social Security income, you should try to stay below the threshold for as many years as possible. Sometimes you can control this by careful timing of when you elect to receive income, e.g., choosing to receive income immediately before or after 12/31.
Aren’t taxes fun?