Learn Tax Strategies for Maximizing Social Security Benefits
Depending on Your Income, You May Be Taxed
If you receive Social Security, you may pay income taxes on up to 85 percent of your Social Security benefits. This rule about the taxation of benefits is different than 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 5b, for the taxable amount. Here's how the taxable amount is determined.
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 capital gains
- Pension or annuity income
- IRA/401(k)/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 percent).
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 will be that you pay taxes on the lower of:
- 85 percent of your Social Security benefits
- 50 percent of the benefits plus 85 percent of the amount of combined income over the second threshold amount
- 50 percent of the amount of combined income over the first threshold amount, plus 35 percent of the amount of combined income over the second threshold amount
You can work through the numbers yourself 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 1040 tax form.
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
Based on step number one above, this makes their combined income $55,000 (which is in excess of the highest threshold amount for marrieds). Using the free Social Security taxation calculator in step two above, 85 percent 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
- Taxable income is $35,400
- Total tax due is $4,388
- After tax funds available to spend = $55,612
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 combined income is $40,000 (which is between the threshold amounts for marrieds). Using the free online Social Security calculator, 10 percent of their Social Security will be taxed, or $4,000 to be input to box 5b. They do not itemize deductions but instead use the standard deduction and exemptions.
- Their AGI is $24,000
- Taxable income is $900
- Total tax due is $90
- After tax funds available to spend = $59,910
In both years the couple has $60,000 of gross income. However, after they are both 70, because a larger proportion of their income comes from Social Security, their tax liability goes down, and they now have more funds to spend. Because of this taxation formula, a couple in the 15 percent bracket can find they pay tax at a much higher marginal rate.
Smart Idea - Use Tax Arbitrage to Your Advantage
Up to 85 percent of your Social Security benefits received can be taxed, but never 100 percent. It means that 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 their retirement years.
Much of this planning has to do with how other sources of income affect how much of your Social Security benefits will be taxable. By planning out the timing of those other sources of income, many can lower their tax bill.