How Does Social Security Affect your Taxes?
Social Security can affect your taxes in a couple of different ways. First, some Social Security benefits are taxable. Depending on how much you make, the government taxes 0%, 15%, or 85% of your social security benefits. Second, Social Security income can bump you into a higher marginal tax bracket that translates to a higher tax liability on your income tax return. It can also lead to unexpected amounts due, as there is usually no withholding on Social Security, so when it becomes taxable, there is no withholding to offset the additional tax due.
Fortunately, there are several strategies for reducing the impact Social Security has on your taxes. Retirement planning can help you determine the best age to retire, what type of Individual Retirement Arrangement (IRA) to use, and how to avoid early withdrawal penalties.
Determining who pays taxes on Social Security benefits.
At one point, all Social Security income was tax-free. When it was first was set up in 1935, it was designed to be a supplement for those who lived beyond the average life expectancy (less than 60 for a male and less than 62 for a female). Over the years, benefits have been expanded and added, costing the Social Security Trust Fund more and more each year. When the beneficiaries withdrawing started to outweigh employees paying into the program in the mid-1980s, Congress decided to tax up to half of Social Security benefits. Lawmakers later added an 85% tax to certain income thresholds to help keep Medicaid funded.
If you are working or self-employed, or receive investment interest or dividends, or have other taxable income, you may owe taxes on your Social Security benefits. However, around 70% of Social Security beneficiaries are not affected by these taxes especially if Social Security benefits are the only income source.
The age that you decide to start collecting retirement benefits will determine how much your monthly monetary benefits. The SSA determines your retirement year by the year you were born. However, everyone can start receiving Social Security benefits at age 62. Since this is not full retirement age and you will receive benefits for 24 additional months, you will receive 75% of your benefit amount available. If you wait until age 65, you will receive 93.3% of the available benefit amount.
If it is viable for you to wait until full retirement age, so you can receive the full benefit amount each month. Waiting could help eliminate the need to work a part-time job to supplement your income. There are formulas to help you determine if it is better to collect earlier, as the longevity of one’s life is never guaranteed.
Income thresholds for single and married taxpayers
The IRS rules indicate different income limits for single and married filers. If your income is under $25,000 when filing a single return or $32,000 when filing a joint return, you will not owe tax on your Social Security benefits. Single filers with an income of $25,000-$34,000 and joint filers with an income of $32,000-$44,000 will pay income tax on up to half of their benefits. Finally, single returns that report over $34,000 and joint returns that declare over $44,000 annually will pay tax on up to 85% of their Social Security benefits.
These amounts are based on provisional income, not gross income. Provisional income includes half of Social Security benefits, plus modified adjusted gross income (AGI). Your modified AGI may include income from non-taxable sources, such as municipal bonds. Municipal bonds are public, tax-exempt investments and are usually included in many retirement portfolios.
Breaking down taxable income
Here are some examples of how income thresholds work:
- Taxpayer A is single and makes $24,000.
- Taxpayers B and C are filing a joint return and have an income of $35,000.
- Taxpayer D is married and filing a separate return for $50,000 of income.
Taxpayer A’s income is below the taxable threshold, so he will not owe taxes on his Social Security benefits. Taxpayers B and C fall into the 50% taxable income range. They will pay income tax on up to $17,500 of their Social Security income. Taxpayer D is treated as single since she is filing a separate return. Her income is subject to the 85% tax rate, which means $42,500 of her Social Security benefits are taxable.
Marginal income tax rates and Social Security income
Although half or more of your Social Security benefits may be taxable, that does not mean that your taxable wages will all be taxed at the same rate. Your effective tax rate depends on the federal tax system, which is divided into seven tax brackets. The tax rates for each bracket range from 10% - 39.6%. Additionally, investment income is subjected to a 3.8% surtax on top of these rates. However, most taxpayers fall into the lowest three brackets: 10%, 15%, and 25%. This means that the first 10% of your income is taxed at a certain rate, the next five at a slightly higher rate, and the next ten at an even higher rate.
|Married/Separate||Head of Household|
|10%||$1 to $9,275||$1 to $18,550||$1 to $9,275||$1 to $13,250|
|15%||$9,275 to $37,650||$18,550 to $75,300||$9,275 to $37,650||$13,250 to $50,400|
|25%||$37,650 to $91,150||$75,300 to $151,900||$37,650 to $75,950||$50,400 to $130,150|
|28%||$91,150 to $190,150||$151,900 to $231,450||$75,950 to $115,725||$130,150 to $210,800|
|33%||$190,150 to $413,350||$231,450 to $413,350||$115,725 to $206,675||$210,800 to $413,350|
|35%||$413,350 to $415,050||$413,350 to $466,950||$206,675 to $233,475||$413,350 to $441,000|
|39.6%||over $415,050||over $466,950||over $233,475||over $441,000|
How Social Security benefits can raise your marginal tax bracket
Sometimes Social Security income may bump you into a higher tax bracket. For instance, assume you are a single taxpayer with a salary of $30,000 per year. This income places you in the 15% tax bracket. Once you reach retirement age, you begin receiving $20,000 in Social Security benefits in addition to your income. This raises your income to $50,000 annually. Since the threshold for the 25% tax bracket is around $38,000, you must pay the higher tax rate.
Calculating Social Security tax
In the example above, 85% of your Social Security benefits are taxable. In other words, you will pay tax on $17,000 of your Social Security income. At the 25% rate, this amounts to a tax bill of $4,250. Note that this amount only reflects the Social Security tax portion. Your full tax liability for this example would be $11,750.
Paying state tax on Social Security benefits
Some states levy income taxes on Social Security benefits. However, if Social Security benefits are your only source of income, you do not need to worry. Your low tax bracket means you likely will not pay taxes on your retirement benefits.
Determining how much you will owe in a given state can get complicated. Most states allow exemptions for at least part of your Social Security income. Currently, 13 states tax Social Security benefits. West Virginia, Vermont, Rhode Island, North Dakota, Nebraska, and Minnesota follow the 0%/50%/85% federal taxation guidelines. Four states collect taxes on a smaller portion of Social Security benefits: Montana, Missouri, Kansas, and Connecticut. Kansas also offers Social Security income exemptions for residents who make less than $75,000 annually. 26 states totally exempt Social Security income from tax.
Colorado, New Mexico, and Utah offer age-based exclusions, meaning that if you’re above a certain age you will not get taxed. However, they also use the federally untaxed portion of Social Security benefits in determining income thresholds. Residents must add either all, half, or 15% of their Social Security income back into their AGI.
Reporting Social Security benefits on your tax return
When your Social Security benefits are taxable, you must file your tax return using Form 1040 or 1040A. You cannot use 1040EZ. If your benefits are tax-exempt, however, you may use Form 1040EZ.
The Social Security Administration (SSA) will send you documentation of your benefits. The forms are mailed in January of each year. If you receive Social Security retirement benefits this year, you will receive Form SSA-1099. If you get Railroad Retirement benefits, the Social Security portion is reported on Form RRB-1099.
Reporting taxable benefits
The total amounts from Box 5 of all SSA-1099 or RRB-1099 forms is your net benefits amount. On Form 1040, record your net benefits on line 20a. Enter the taxable portion on line 20b. Use different lines if you are filing Form 1040A. Enter your net benefits on line 14a, then record the taxable part on line 14b.
Reporting non-taxable benefits
If you file Form 1040EZ, you are not required to report any benefits. On Form 1040 or 1040A, record your net benefits on the appropriate line. Enter a zero for the taxable portion. The worksheet in Internal Revenue Service (IRS) Publication 915 can help you determine whether your Social Security benefits are taxable. If you use tax preparation software to e-file, it will figure the amounts for you.
Avoiding early benefit penalties
Going from a full paycheck to only receiving Social Security can be quite a drop in income. Many retirees plan on working part-time while they draw Social Security benefits. Unfortunately, there can be penalties involved if you access benefits before full retirement age. The SSA determines full retirement age depending on the year you were born. For example if you were born between 1943 and 1954, your full retirement age is 66.
SSA earned income cap
If you take early Social Security retirement benefits and continue to work, the SSA caps the amount you can earn before they reduce your Social Security payments. The earned income cap for 2017 is $16,920. If you work and collect Social Security and earn more than this cap amount your benefits will be reduced by $1 for every $2 over the limit that you earn.
Here is how it works. Assume you earned $25,000 for the year, and you receive $15,000 annually in Social Security benefits. Your earned income exceeds the cap by $8,080, so your benefits are reduced by $4,040. You will have to repay these excess benefits through reduced monthly benefit checks until you've repaid the entire amount.
The good news
Fortunately, married couples may have some options for reducing early benefit penalties. If you retire early and your spouse does not consider filing a separate return. This way, your spouse’s income will not affect your earned income cap. If you file jointly, spousal income factors into the benefits you receive.
The penalty is not permanent either. Once you reach full retirement age, you are no longer subject to benefit cuts, regardless of working status.
Reducing taxes on Social Security benefits
You can use several strategies to lower taxes on your Social Security benefits. One of the simplest ways to do this is keeping your income below the threshold level. For example, if you and your spouse work but your provisional income is below $32,000, your Social Security benefits are tax exempt.
The Social Security income thresholds are not indexed for inflation. As time passes, more and more people will be affected by benefit taxes. Keeping income at a low level is a short-term strategy at best. Take a look at these long-term strategies for retirement planning.
Converting 401(k) or traditional IRAs to Roth IRAs
You may be better off converting a traditional retirement plan to a Roth IRA. The pre-tax contributions to 401(k) plans or IRAs mean that distributions count as part of your taxable income. Since regular IRAs have Required Minimum Distributions (RMDs) after a certain age, you could be pushed into a higher tax bracket. RMDs may increase your tax on Social Security payments too.
One option is to convert your traditional retirement plan to a Roth IRA. You pay tax on each contribution you make to it, so distributions are tax-free. You can also withdraw funds as needed once you reach retirement age, rather than being forced to take an RMD. However, expect a large tax bill when you convert, especially if you have substantial savings in a traditional account. Since all previous contributions have been tax-free, you must pay taxes on them at the time of conversion.
When not to convert
Converting to a Roth IRA is a sound long-term strategy, but it may not work well in the short-term. Also, you may not want to convert if you are going to keep working during retirement. IRA and 401(k) contributions reduce your taxable income, which may help offset some of your earnings. If using traditional retirement plans drop you into a lower tax bracket, it may be smarter to avoid conversion for now.
Avoiding a massive tax bill
You may be able to reduce the amount of taxes you pay when April 15th rolls around. You do not need to wait until the end of the year to file and pay taxes; you can have the IRS deduct taxes from your Social Security check each month. Although you are technically still paying the same amount, prepaying taxes can reduce the amount you still owe, and you may receive a refund if you overpay.
There are two methods for pre-paying taxes. First, you can file Form W-V4 with the Social Security Administration. This approach withholds taxes from your benefit checks. Second, you can pay quarterly estimated tax payments, which is similar to paying quarterly taxes on investment income. These payments, made on Form 1040-ES, are paid once each quarter.
Most Social Security beneficiaries do not have to worry about the intricacies of paying taxes on their earnings. If you are one of the 30% who does pay taxes on this type of retirement income, there is no need to be concerned. Wise retirement planning and pre-paying taxes can help you avoid paying too much. If you need recommendations for your retirement plan, ask an Expert to help guide you.