Social Security benefits are not subject to federal income tax on their own; however, when combined with other retirement income, your total income can exceed the threshold.
According to the Social Security Administration, around 56% of beneficiaries will owe federal income taxes on their payments. How do you figure out how much you’ll owe? Calculate your provisional income first.
Half of your Social Security benefits, plus all other taxable income including dividends, realized interest, and realized capital gains, are included in provisional income. Non-taxable interest earnings, such as those from municipal bonds, should also be included.
If your provisional income is between $25,000 and $34,000, you may have to pay income tax on up to 50% of your benefits if you file a federal tax return as an individual.
If your provisional income exceeds $34,000 and you file as an individual, up to 85% of your benefits may be subject to taxation.
If your provisional income is between $32,000 and $44,000, you may have to pay income tax on up to 50% of your benefits if you’re married and filing jointly. If your combined income exceeds $44,000, up to 85% of your benefits may be subject to taxation.
Subtract the first threshold from the provisional income and multiply it by.5. Then multiply by.35 after subtracting the second threshold.
Add the numbers together. The taxable amount is the difference between the total amount and the maximum amount. The taxable amount is the maximum if the entire amount exceeds the maximum.
Many people assume that if they go above the first taxable threshold, their whole Social Security payout becomes taxable. That isn’t the case at all. Instead, only half of the amount above the threshold is subject to taxation.
Let’s see an example – A married couple files their taxes together. They have Social Security benefits of $40,000 and IRA withdrawals of $30,000. We add half of their Social Security benefits ($20,000) to the $30,000 in IRA withdrawals to arrive at their provisional income. They have a preliminary income of $50,000.
We then multiply by.5 and deduct $32,000, which is the initial barrier for married couples. This gives us a total of $9,000. Then remove the second criterion for married couples ($44,000) from the provisional income ($50,000) and multiply by.35 to get $2,100. For a total of $11,000 in taxable benefits, add the $9,000 and the $2,100.
It’s worth noting that, when compared to other forms of income, Social Security has a large tax benefit. In the worst-case scenario, 85% of benefits are taxed, while 15% are tax-free.
It’s critical to understand your various retirement income streams and how they interact. Middle-income retirees can devise tax-efficient retirement strategies by carefully selecting which accounts to withdraw from at various stages of retirement, including Social Security.
A skilled financial advisor can help you figure out how much of your benefit is taxable and which account to utilize and when to help you meet your retirement goals.