If you receive Social Security, you may pay income taxes on up to 85% of your Social Security benefits. This rule about the taxation of benefits is different from the earned income rule, which applies if you receive benefits before your full retirement age, continue to work, and earn amounts in excess of the earnings limit.
The formula that determines the taxation of benefits applies to everyone, regardless of age. If you look at a 1040 tax form, you will see two boxes; box 5a, for total Social Security benefits, and box 5b, for the taxable amount. Here's how the taxable amount is determined.
- If you receive Social Security, you may pay income taxes on up to 85% of those benefits.
- The specific amount you'll be taxed depends on your individual situation, such as whether you have additional income and whether you're married.
- Designing a retirement income plan that takes advantage of this tax arbitrage can make a big difference over the course of your retirement years.
Determine What Your Combined Income Will Be
Do you have income in addition to Social Security? Additional sources of income that would show up on your tax return include items such as:
- Wages (earnings or self-employment income)
- Investment income from interest, dividends, and/or capital gains
- Pension or annuity income
- IRA, 401(k), and/or 403(b) withdrawals
- Rental property income
Social Security defines your “combined income” as the total of your adjusted gross income plus nontaxable interest, plus one-half of your Social Security benefits. Roth IRA withdrawals do not count as combined income, but municipal bond interest does. Your combined income is compared to the threshold amounts in the table below.
|First Threshold ($)||Second Threshold ($)|
If your combined income is less than $25,000 for single filers or less than $32,000 for married filers, then your Social Security benefits will not be taxable for that calendar year.
If your combined income exceeds the first threshold amount, then a more complex formula is used to determine what portion of your benefits will be taxable (up to a maximum of 85%).
Plug Your Combined Income into the IRS Social Security Worksheet
If your combined income exceeds the threshold amounts, an IRS formula is applied to determine how much of your benefits are taxable. The result of these calculations is that you will pay taxes on the lowest of:
- 85% of your Social Security benefits
- 50% of the benefits plus 85% of the amount of combined income over the second threshold amount
- 50% of the amount of combined income over the first threshold amount, plus 35% of the amount of combined income over the second threshold amount
You can work through the numbers yourself by using the IRS Figuring Your Taxable Benefits worksheet. You can also use a free online calculator called How Much of My Social Security Benefit May Be Taxed, to come up with a rough estimate of the dollar amount of benefit that would need to go into box 5b (the taxable amount box) on your Form 1040.
Social Security Taxation for Married Couples
Let’s look at an example for a couple, both age 67, who are married and file jointly. One is collecting a spousal Social Security benefit. They are both waiting until age 70 to claim their full retirement benefit amounts, so they can get the most possible. While delaying, they are taking large withdrawals from a traditional IRA. Here’s a snapshot of their income sources.
- $10,000 gross Social Security income
- $50,000 IRA withdrawal
The first step in the process is to calculate your "provisional" income. This is done by taking 50% of your social security benefit and adding it to your other sources of income; the IRA withdrawal in this case. Based on the first step, this makes their combined provisional income $55,000 ($10,000 x .50 + $50,000, which exceeds the highest threshold amount for married couples filing jointly). Using the free Social Security taxation calculator in step two above, 85% of their Social Security will be taxed, or $8,500 that will be input to box 5b. They do not itemize deductions but instead use the standard deduction and exemptions.
- Their adjusted gross income (AGI) is $58,500
- Their standard deduction is $24,800
- Additional deduction for both spouses being over age 65 is $2,700
- Taxable income is $31,000
- Total tax due is $3,328
- After-tax funds available to spend = $55,172 (assuming no state tax)
Now let’s look at this same couple three years later. Both are age 70 and receiving their full Social Security amounts. Here’s a snapshot of their income sources.
- $40,000 gross Social Security income
- $20,000 IRA withdrawal
Their provisional income is $40,000 ($40,000 x .50 + $20,000). This figure is between the threshold amounts for married couples filing jointly. Using the free online Social Security calculator, we see that 50% of their Social Security will be taxed, or $20,000 to be input to box 5b. They do not itemize deductions but instead use the standard deduction and exemptions.
- Their AGI is $40,000 ($40,000 x .50 + $20,000).
- Their standard deduction is $24,800.
- Additional deduction for both spouses being over age 65 is $2,700.
- Taxable income is $12,500.
- Total tax due is $1,253.
- After-tax funds available to spend = $58,747 (assuming no state tax).
In both years, the couple has $60,000 of gross income. However, after they are both age 70, because a larger proportion of their income will come from Social Security, their tax liability will go down, and they will have more funds to spend.
Smart Idea: Use Tax Arbitrage to Your Advantage
Up to 85% of your Social Security benefits received can be taxed. After taxes, a dollar of Social Security income is worth more than a dollar of IRA withdrawals.
If you design a retirement income plan that takes advantage of this tax arbitrage, it can make a big difference over the course of your retirement years. You can pay less in tax and have more to spend.
There are many ways you can plan to reduce taxes when you begin withdrawing money. The most common strategy is to delay the start of your Social Security benefits to age 70 while taking IRA withdrawals or using Roth conversions in your 60s. It isn't the best option for everyone, but for many families, this approach results in less total taxes during retirement years.
Much of this planning has to do with how other sources of income will affect how much of your Social Security benefits will be taxable. By planning out the timing of those other sources of income, many people can lower their tax bill.