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You are correct if you are under retirement age and started collecting your SS, if you earn more than the maximum wage limit of $14k then SS will reduce your SS by the $1 to $2 ratio.
If in 2010 you went over the amount and did not notify the SS Administration so they continued to pay your benefits in 2010 and are over the $25/$32k income limit it would be taxable in 2010. SSA will now withhold SS benefits in 2011 until the point you have paid back what is required.
When you receive your 2011 SS tax statement it will contain what you actually received, not what you were entitled to so your taxable SS for 2011 will be less. You will pay less tax in 2011 because the benefits that you receive will be less.
Where this could be problematic is if the SS benefits were taxable in 2010 but your income is low enough in 2011 to avoid the SS being taxable. Unfortunately, there is no option to re-capture the tax paid. SS Administration will tell you that you should have notified them in 2010 and stopped your benefits then not wait for SSA to catch up with you in 2011.
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If they are not withholding, it almost sounds like you were hired as an independent contractor or subcontractor - basically they consider you in business for yourself which means that you will owe the SE tax. This you should have paid as part of your income tax filing. The SE tax pays the SS taxes for the income earned, it does not re-pay the SS benefits.
Is the $7000 or not paying me - are you talking about the SS Administration or are you talking about your employer?
If you are talking about the SS Administration to re-pay the excess from 2010 - then I would allow them to withhold your benefits for the 5 months and not pay out the $7000. The SSA does not charge you interest or issue penalties if you just let them withhold the benefits for 5 months. If you pay it out of pocket, you would have more SS benefits in 2011 that would be taxable so you are better off letting them withhold the benefits.
If you are talking about the employer and them paying you for 2011 work, you can elect to delay the payment to change the loss of benefits by you not billing them until later.
No you do not have the ability to reduce the income in 2010 by the $7000 and recover the taxes. You would have had to have them stop the benefits in 2010 rather than letting them keep 2011 benefits.
So, let them take the remaining payments and call it even. You will basically have paid the tax in 2010 rather than the tax in 2011, net effect is zero.
No, since we are cash basis taxpayers if you were to repay it then you could take the deduction for the repayment in 2011. It however would be a 2% misc deduction on Sch A which means you would lose the first 2% of AGI before you could take it.
So for example is your AGI (number on the bottom of page 1 of your Form 1040) was $200,000 then you would lose the first $4000 and could only take a deduction for the remaining amount over and above that.
Since you indicated your wife makes about $150k I think the 2% loss in this case would make the repayment not worth it. Whereas if you take the same amount and just not get it in 2011 then you are reducing your SS benefits received and the full amount would not be included as part of your AGI.