Navigate The Tax Rules For Social Security Benefits
Roughly 1 in every 2 older adults will pay federal income taxes on a portion of their Social Security benefits for the 2020 tax year.
This usually happens only if you have other substantial income in addition to your Social Security benefits, such as wages, self-employment, interest, dividends and other taxable income that must be reported on your tax return.
Will you owe? Here's how to know
If you file a federal tax return as an "individual" and your income is:
Between $25,000 and $34,000: You may have to pay income tax on up to 50% of your benefits
More than $34,000: Up to 85% of your benefits may be taxable.
If you file a joint return, and you and your spouse have a income that is:
Between $32,000 and $44,000: You may have to pay income tax on up to 50% of your benefits.
More than $44,000: Up to 85% of your benefits may be taxable.
And if you are married and file a separate tax return, you probably will pay taxes on your benefits.
What is 'combined income'
and how is it calculated?
It's your adjusted gross income or AGI plus your nontaxable interest plus half of your Social Security benefits.
Now the thing about these taxes is this: No one should really be surprised by them. These taxes on Social Security have been with us since the Greenspan Commission created them in 1983, according to David Freitag, a financial planning consultant with MassMutual.
But you might be surprised by the following details:
The thresholds are not indexed for inflation. "So as income in retirement has increased, more and more people are paying more and more income tax on their Social Security benefits," Freitag explains.
Others see the same trend. "Because the thresholds that determine whether or not Social Security benefits are taxable were never adjusted for inflation, it is pretty hard today to avoid paying taxes on Social Security benefits," says Elaine Floyd of Horsesmouth.
How to reduce
Social Security taxes
It's hard to reduce those taxes but it's not impossible.
If you can lower your adjusted gross income or AGI, you can reduce the amount of tax created on your Social Security benefit, Freitag explains.
There are two common ways to lower your AGI – and another, which which is less common: Take distributions from your Roth IRA, which are generally tax-free, vs. your traditional IRA.
Or take certain distributions from your cash-value life insurance policy, if you have one. Taking money from a reverse mortgage, if you have one, is yet another way to create a cash flow that could help reduce how much income tax you might pay on your Social Security benefits.
How to plan for
Social Security taxes
A balanced approach to distribution is the best way to plan for Social Security taxes, says Freitag. Keep in mind that too much emphasis on one type of distribution or another is not the way to go.
"It is better to have a mix of income streams in retirement," he says. "As an example, if all your income is taxable, then adding Social Security just makes it worse across the board."
Don't procrastinate, estimate
People need to plan for these taxes when they first start receiving Social Security, stresses Floyd. "Don't wait until the year is over and you are doing your taxes to discover that you owe taxes on the Social Security income you received the prior year," she says.
"At the time you start benefits, estimate how much income you will receive during the rest of the year and pay the taxes as the income is received."
There are two ways to do this, Floyd notes.
Change your withholding rate. File Form W-4V with the Social Security Administration requesting an amount to be withheld for taxes. The choices are 7%, 10%, 12%, and 22%. These percentages, she notes, apply to the full income, not the 85% that is taxable.
Don't pay all at once. If you already file quarterly estimated tax payments, then tack on your social security income.
Will I owe on my state taxes, too?
It's worth noting too that most states – 37 at last count, don't tax Social Security – but a baker's dozen do.
According to AARP, those states are: Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont and West Virginia
Maintain perspective
It's wise to maintain the proper perspective about these taxes, Floyd says. After all, 15% of Social Security income is tax-free.
Freitag concurs: "Social Security benefits are always tax-advantaged over distributions from traditional IRAs," he says. "The traditional IRA distribution is always reported at 100% while the maximum reporting rate for Social Security is capped at 85%. In retirement Social Security dollars always go farther than dollars taken from a traditional IRA."
And remember, income taxes are the price we pay to live in society.
"The taxes the U.S. government collects on Social Security benefits go into the Old Age, Survivors and Disability Insurance or OASDI trust fund to help keep the system going," Floyd points out. "In 2020, the trust fund collected $39 billion taxes, representing about 4% of the trust fund's total income."
Robert Powell
Columnist
USA TODAY
RMC pays out $542,000 in severance for month of December
North Huntingdon company lands Defense Department contract for 3D printing lab
Advisor News
Annuity News
Health/Employee Benefits News
Life Insurance News