About one-third of Social Security recipients — and probably the majority of financial advisers' clients — pay federal income taxes on a portion of their benefits. The taxes usually hit when the recipients have other substantial income such as wages, self-employment, interest, dividends and other taxable income that must be reported on their federal tax return in addition to their Social Security benefits.
Social Security benefits are subject to federal income taxes, regardless of age, if income rises above certain thresholds known as “combined income,” which is the sum of adjusted gross income from Line 37 of the IRS 1040 form, plus non-taxable interest, plus one-half of Social Security benefits. As the income brackets have not changed since 1994, more and more retirees must pay this stealth tax as their income rises due to annual cost-of-living increases.
Individuals with combined income between $25,000 and $34,000 pay taxes on up to 50% of their Social Security benefits. If their combined income is more than $34,000, up to 85% of their Social Security benefits are subject to income tax.
Married couples filing a joint return have to pay taxes on 50% of their Social Security benefits if their combined income is between $32,000 and $44,000. If their combined income is more than $44,000, up to 85% of their Social Security benefits are subject to income tax.
But the specific rules that determine how much of the benefits are taxable are fairly complicated. There is a three-part test that determines the amount of Social Security benefits subject to tax based on the lower of:
• 85% of Social Security benefits.
• 50% of Social Security benefits plus 85% of combined income over the second threshold.
• 50% of combined income over the first threshold plus 35% of combined income over the second threshold.
Does your head hurt yet? Mine does!
Frank Horath, president of Client First Financial, a Social Security training program for financial advisers, recently gave me a demonstration of his new PowerPoint presentation on taxation of Social Security benefits.
Mr. Horath demonstrated the tax calculation process with the following scenario: Bob and Jane, a retired married couple, have an annual income of $76,000, composed of $40,000 in Social Security benefits and $36,000 in other income.
Under the first test, their combined income would be $56,000, based on one-half of their Social Security benefits ($20,000) plus their $36,000 in additional income. Because $56,000 is higher than the $44,000 level that triggers the second income tier for married couples, 85% of their Social Security benefits — $34,000 ($40,000 x 0.85) — would be taxable.
But hold on. That's just the result of the first test. There are still two more tests to consider. The amount of Social Security benefits that are taxed is based on the lowest amount of the three tests.
Under the second test, 50% of Social Security benefits ($20,000) are added to 85% of the income that exceeds the second tier. In this case, the couple's combined income of $56,000 (one-half of Social Security benefits plus $36,000 in other income) exceeds the second tier threshold of $44,000 for married couples by $12,000 ($56,000 - $44,000). Eighty-five percent of $12,000 is $10,200. So the result of the second test is $30,200 ($20,000 + $10,200).
But wait. There's more!
The third test adds the sum of 50% of the combined income over the first threshold ($56,000 -$32,000 = $24,000/2 = $12,000) and 35% of the combined income over the second threshold ($56,000 - $44,000 = $12,000 x .35% = $4,200) for total taxable income of $16,200.
Therefore, Bob and Jane would pay taxes on $16,200, which is the result of the third test and the lowest amount of the three tests. They would be taxed at their ordinary income tax rate.
Social Security benefits weren't always taxable. The change was the result of Social Security reform legislation designed to shore up the long-term finances of the system.
Under legislation enacted in 1983, the Social Security Trust Funds receive income based on taxes on up to 50% of benefits from single and married taxpayers with incomes over the first threshold.
Subsequent legislation enacted in 1993 extended taxation of benefits to 85% from 50% for single taxpayers with incomes over $34,000 and for taxpayers filing jointly with incomes over $44,000. All additional tax income resulting from the 1993 legislation is deposited in Medicare's Hospital Insurance Trust Fund.
Each January, retirees receive a Social Security Benefit Statement (Form SSA-1099) showing the amount of benefits they received in the previous year that they can use to determine how much of their benefits are subject to tax. They can make quarterly estimated tax payments to the IRS or choose to have federal taxes withheld from their benefits by filing IRS Form W-4V, Voluntary Withholding Request.
(Questions about Social Security? Find the answers in my e-book.)