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Do I have to pay tax on Social Security?

Do I have to pay tax on Social Security? (Yes)

Background

“Social Security benefits aren't taxable”. That was true up until 1984. But in 1983, a number of changes were made to the Social Security Act, on reccomendations from The National Commission on Social Security Reform (NCSSR), chaired by Alan Greenspan. Its three major recommendations were:

1.     Delaying COLA[1] adjustments

2.     Changing the tax bands for Social Security payments

3.     Additional employees added to the system

4.     And, yes, taxing benefits.

So, if you have employment or investment income, including withdrawals from retirement savings plans, you could owe federal income taxes on up to 85% of your benefits.

Here’s how it works.

Social Security taxes are based on your combined income, which is not the same as Adjusted Gross Income. It’s:

Your adjusted gross income
+ Nontaxable interest (e.g. muni bond interest)
+ ½ of your Social Security benefits
 = Your "combined income"

This includes:

  • employment income

  • interest

  • dividends

  • taxable gains from investments

  • municipal bond interest

  • taxable portion of IRAs and Annuities

  • pensions

  • rental income

And excludes

  • Roth IRA withdrawals

So, if your combined income is:

  • Less than $25,000 if you're single or $32,000 if married, all Social Security benefits are tax-free.

  • Between $25,000 and $34,000 for singles and $32,000 and $44,000 if married, you will be taxed up to 50% on Social Security benefits.

  • More than $34,000 for singles and $44,000 if married, you will be taxed up to 85% on Social Security benefits.

Ok, got it. How about state taxes? Does it matter where I live?

Oh yes. Take a bow, the 13 states that tax Social Security:

  • Minnesota, North Dakota, Rhode Island, Vermont and West Virginia tax up to 85% of Social Security benefits.

  • Colorado, Connecticut, Kansas, Missouri, Montana, Nebraska, New Mexico and Utah tax a portion of Social Security benefits but provide exemptions based on income or age

 Here are some examples

 1. Single retiree receiving the following:

  • Social Security benefits = $15,000 per year

  • IRA withdrawal = $12,000 per year

  • Taxable investment income = $12,000 per year

So, combined income is $24,000, plus $7,500, (i.e. half Social Security), or $31,500.

That's between $25,000 and $34,000, and that means the maximum amount of Social Security benefits subject to tax is 50%. So, you will pay income tax on $31,500.

But that’s only the maximum amount that will be taxed. Deductions and exemptions will also apply so in most cases, the portion of Social Security benefit that actually gets taxed will be smaller than the 50% or 85% maximum.  A CPA should confirm precise tax amounts owed.

 Ok, I know what I pay, now how do I pay?

You can choose to make quarterly estimated tax payments, or have taxes withheld from Social Security checks throughout the year.

Currently, the Social Security Administration gives beneficiaries the option to have 7%, 10%, 15%, or 25% of their benefits withheld for taxes. If you choose these, it could prevent you having to pay a big tax bill at the end of the year.

Anything else?

Of course. One strategy to reduce or eliminate taxes on benefits involves converting some or all traditional IRA assets to a Roth.  IRA withdrawals from a Roth IRA aren't included in the calculation. Converting a traditional IRA to a Roth IRA could trigger higher taxes on benefits in the year of the conversion, because the amount converted is included as part of adjusted gross income. But after that, the Roth withdrawals don't count towards your combined income.

[1] Cost of Living

A few other facts

  • Social security benefits paid to a green card holder are not subject to 30% witholding

  • U.S. residents in certain countries are exempt from U.S. tax on their benefits

  • Under a treaty with India, benefits paid to individuals who are both residents and nationals of India are exempt from U.S. tax if the benefits are for services performed for the United States

  • There are special (and mostly favorable) rules if covered under the Railroad Retirement Board

Some helpful websites

Social Security Administration

California Franchise Tax Board on Social Security

IRS Guidelines on taxing Social Security  

A quick calculator (but check with a CPA)