Understanding How Social Security is Taxed

As you near or enter retirement age, it is important to identify the different income streams available to you, as well as how much income you project to receive from each specific source. Among these considerations is Social Security, which can be a significant piece of the retirement income puzzle.  

The purpose of this article is to address the common misconceptions about how Social Security is taxed.

Is your benefit taxed? If so, how much is subject to taxation? At what rate?

The Basics of Social Security Taxation

To fully visualize your retirement income bottom line, it is important to understand the potential tax implications of your Social Security benefits.

Your other income sources may affect the degree to which your Social Security benefit will be subject to taxation. Having substantial income in addition to your monthly Social Security benefit makes it more likely that you’ll pay taxes on a portion of your benefit.

The amount of your benefit subject to taxation is determined by your tax filing status and your combined income (also known as provisional income), defined as:

Combined Income = Adjusted Gross Income + Nontaxable Interest + ½ of your Social Security Benefits

Your combined income is then applied to the following rate schedule (as of the 2023 and 2024 tax years) based on filing status:

The taxability follows a tiered schedule, similar to how ordinary income tax is treated. Here is where it is important to distinguish the difference between the percent of your benefit that is taxable and the rate at which each taxable portion of your benefit is taxed.

Tip: State taxation of Social Security benefits varies from state to state. Be sure to check how your state treats these benefits so you are not hit with an unexpected tax bill.

Let’s look at an example:

John is a single filer, who earned Social Security benefits of $16,000, and has other income of $32,000.

Step 1: Calculate combined income
Combined income = $32,000 + $8,000 (1/2 of his Social Security benefit)

• Using the formula above we can calculate John’s combined income of $40,000

Step 2: Determine John’s combined income in excess of each threshold

• John’s combined income of $40,000 exceeds all the various thresholds, so we know that some of his benefits will be taxable.

Step 3: Calculate John’s total benefit subject to taxation

For a single filer, 50% of the benefit is taxable for combined income that falls between $25,000 and $34,000. For John, this equates to $4,500 ($34,000-$25,000 x 50%)

For a single filer, 85% of the benefit is taxable for combined income that exceeds $34,000. For John, this equates to $5,100 ($40,000 combined income - $34,000 x 85%)

• Adding these two together, John will have a total of $9,600 of benefits subject to taxation ($4,500 from the 50% bracket and $5,100 from the 85% bracket)

Tip: Taxable Social Security benefits are subject to ordinary income tax rates.

Key Considerations for Managing Social Security Taxation

It should be clear by now that overall income (and not just the benefits themselves) drives the taxation of Social Security benefits. This requires a thorough understanding of a retiree’s tax situation and mindfulness of how the increased taxation of benefits might affect your tax bill. Many retirees mismanage their overall income situation and make small decisions that result in substantial impacts on the taxation of their benefits.

Here are some examples of income types that need to be considered when determining your tax situation as it relates to Social Security:

• Wages, self-employment income, and/or pension benefits
• Taxable distributions from retirement accounts
• Realization of capital gains
• Dividends and interest
• Municipal bond interest (Nontaxable Interest)

For a video on this topic, as well as a similar example for a married couple, check out this short clip from our Byte Size Retirement Series.

Unraveling the layers of how Social Security is taxed and the implications of it may subsequently trigger many other questions, such as how to minimize or avoid taxes on your benefit. If you are interested in continuing this conversation for your own, unique situation, click here to contact our team of advisors, who can assist you with the planning considerations involved in a Social Security analysis.

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