Contributed by: Kali Hassinger
Throughout our entire working lives, our hard-earned cash is taken out of each paycheck and paid into a seemingly abstract Social Security Trust fund. As we see these funds disappear week after week, the pain of being taxed is hopefully somewhat alleviated by the possibility that, one day, we can finally collect benefits from the money that has been alluding us for so long. (Maybe you’re also comforted by the fact that you’re paying toward economic security for the elderly and disabled – or maybe not, but I’m an idealist).
When the time to file for benefits finally arises, however, it may not be clear how this new source of income will affect your tax situation. Although no one pays tax on 100% of their Social Security benefits, the amount that is taxable is determined by the IRS based on your “provisional” or “combined” income. Provisional and combined income are terms that can be use interchangeably, so we will just use provisional from this point forward. Many of you may not be familiar with either term, but I’ll bet it’s no surprise that the beloved IRS uses a system that can be slightly confusing! No need to worry, though, because I’m going to provide you with the basics of Social Security taxation.
Determining your provisional (aka combined) income requires the following formula:
Adjusted Gross income (AGI) includes almost all forms of income (salaries, pensions, IRA distributions, ordinary dividends, etc.), and it can be found on the 1st page of your Form 1040. AGI does not, however, include tax exempt interest – such as dividends paid from a municipal bond or excluded foreign interest. These can be powerful tax tools in individual situations, but they won’t help when it comes to Social Security taxation. The IRS requires that you add any tax-exempt interest received into your Adjusted Gross Income for this calculation. On top of that, you have to add ½ of your annual social security benefits. The sum of these 3 items will reveal your provisional income for Social Security taxation purposes.
After determining the provisional income amount, the IRS taxes your Social Security benefits using 3 thresholds: 0%, 50%, or 85%. This means that the maximum portion of your Social Security Benefits that can be considered taxable income is 85%, while some people may not be taxed at all. The provisional income dollar amount in relation to the taxation percentage is illustrated in the chart below:
As you can see, it isn’t difficult to reach the 50% and 85% thresholds, which can ultimately affect your marginal tax bracket. These thresholds were established in 1984 and 1993, and they have never been adjusted for inflation. The taxable portion of your benefit is the taxed at your normal marginal tax rate.
Social Security, in general, can be a very confusing and intimidating topic, but it is also a valuable income resource for all who collect benefits. Everyone’s circumstance is different, and it’s important to understand how the benefits are affecting your tax situation. I encourage you to speak to your CPA or Financial Planner with any questions.
Kali Hassinger, CFP® is a Registered Client Service Associate at Center for Financial Planning, Inc.
This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Kali Hassinger and not necessarily those of Raymond James.