If you have sources of income in addition to Social Security, then you may have to pay taxes on your Social Security benefits. Those additional sources of income include items such as wages, self employment income, interest and dividends, pension income, and IRA/401k withdrawals.
First, Determine What Your Combined Income Will Be
To determine if you will pay taxes on your Social Security benefits you must come up with an estimate of what you think your combined income will be. Social Security considers your “combined income” the total of your adjusted gross income plus non-taxable interest, plus one half of your Social Security benefits. Note that ROTH IRA withdrawals do not count in this formula but municipal bond income does.
Second, A Formula Determines How Much of Your Social Security Income is Subject to Taxation
The actual IRS formula takes your combined income and applies several tests to it to determine what portion of your Social Security benefits will be subject to income taxes. You can use a free online calculator called How Much of My Social Security benefit May be Taxed to see how it works. Please note, however, this calculator is only showing you the amount of tax due on your Social Security benefits based on your estimated marginal tax bracket that you input. It is not calculating your entire tax liability.
If you want to gain a better understanding of how the Social Security taxation formula works check out Prudential's Innovative Strategies to Help Maximize Social Security Benefits. This brochure offers a detailed explanation of how the Social Security taxation formula works and why it should matter to you.
Third, Smart Idea - Use Tax Arbitrage to Your Advantage
There are many ways you can plan to reduce taxes when you begin withdrawing money. Much of this planning has to do with how other sources of income affect how much of your Social Security benefits will be taxable. The three articles that I have found most useful in explaining some of the strategies available are:
Social Security Tax Breaks Drive New Retirement Strategy at US News & World Report. This article provides a good overview of why planning around the taxation of your Social Security benefits makes sense and how it works.
- Another Good Reason to Delay Social Security by Jim Blankenship. This article provides a specific example of how delaying Social Security and taking IRA withdrawals early can lower your tax bill in certain circumstances.
- Ideal ROTH conversion candidate - Protecting Non-Taxation of Social Security by Jim Blankenship. This article shows how converting to a ROTH IRA early in retirement may result in tax savings over your retirement years.
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.
For additional details see a series of case studies on Social Security taxation to see examples of how much tax you may pay depending on your other sources of income.
Fourth, Watch Out - Estimating Is Ok, But It Has Its Limitations
If lieu of crunching through the Social Security taxation formula, use the guidelines below only as an estimate in determining if you will pay income tax on your Social Security benefits. They are only an estimate because the way the formula works, for most tax payers it is not as simple as just crossing one of the income thresholds below and suddenly 85% of your benefits are taxed. Instead, as your income in addition to Social Security goes up, more and more of your benefits become subject to taxation. (As I mentioned above, you can see case studies for more detailed examples.)
Income Thresholds Used in Social Security Taxation Formula for Married Filers
- If you are married and your combined income exceeds $44,000, then up to 85% of your Social Security benefits may be taxable.
- If you are married and your combined income falls between $32,000 and $44,000 then up to 50% of your Social Security benefits may be taxable.
Income Thresholds Used in Social Security Taxation Formula for Individual Filers
- If you file as an individual and your combined income exceeds $34,000, then up to 85% of your Social Security benefits may be taxable.
- If you file as an individual and your combined income falls between $25,000 and $34,000 then up to 50% of your Social Security benefits may be taxable.
For additional information read:
- Taxes and Your Social Security Benefits
- Publication 554, Tax Information For Older Americans
- IRS Publication 915 – Social Security and Equivalent Railroad Retirement Benefits