Hey guys, Mike Frontera here back with another Retirement Theory video! Well…it’s finally time to claim your Social Security benefits. You grab your latest estimate and drive down to your local Social Security office. Or you open up your laptop and merge onto the information superhighway to www.ssa.gov, whatever. You verify the benefits you’ve been expecting and then you get a question you’re not expecting. Would you like taxes withheld from your benefit? Wait, what?? My Social Security check is taxable? Well I’m afraid like many things in the financial world, the answer is definitely yes…maybe.
First things first, let’s take a minute to gripe about how much paying taxes on Social Security stinks. I probably don’t need to remind you that your benefits are funded from taxes. That friend of yours, FICA, who has shown up for a taste of every paycheck since you bagged groceries in high school. Well FICA, who’s full name is actually Federal Insurance Contributions Act is what pays for Social Security. And for Medicare. And now you finally get to reap what you’ve sown all these decades later, our pals at the IRS want a second bite of the apple- by taxing you on these benefits. Well not if we can help it.
Alright, you’ve got my attention—let’s get to it. How do we avoid paying income taxes on Social Security? We do so by being vigilant about our other income and sliding under the limbo bar of a certain tax test. The test is called Provisional Income. Let’s see how it works!
Well the first step is you get out Worksheet 1 from IRS publication 915. Here you can plainly see in just 8 to 19 short steps, where you stand. Hmmm, ok this looks really, really hard.
We can simplify it down to 3 steps for the vast majority of people.
- Look at your Adjusted Gross Income without your Social Security Benefits – let’s do an example and here let’s say it’s $28,000 for a married couple, filing jointly. Here they are, Jerry and Ginny.
- Next we add back in half of your Social Security Benefits. Jerry and Ginny received $30,000 in benefits, so we add half of that, or $15,000 to the Adjusted Gross Income. Tacking that onto the $28,000 from step one, and we have $43,000
- Add any tax-free interest to this total. So that could be interest from municipal bonds, for instance. OK, so here we’ll say there's $1000 for that. Jerry and Ginny’s total provisional income is now $44,000.
OK, got our provisional income. We now need to be aware of two income thresholds. If we’re married filing jointly, like Jerry and Ginny, the first threshold is $32,000. It’s $25,000 if your single. If your provisional income is less than that threshold, congratulations your Social Security benefits are tax-free!
Turns out in our example however, that Jerry and Ginny exceed that threshold. And every dollar that exceeds that threshold increases how much your Social Security benefits are taxed by 50 cents. And that happens for every dollar extra….until we hit the next Threshold. And that next threshold…is $44,000. $34,000 if you're single. Now $44,000 just so happens to be exactly what Jerry and Ginny’s provisional income came out to in my example! They love making my calculations easy! Had it been higher, every dollar beyond that second limit would increase the amount of SS subject to tax by 85 cents. Does the madness ever end? Yes. The highest amount of your Social Security benefits that would be subject to taxation is 85%. So the good news is you’ll always get 15% of your benefits tax-free. How nice! Subject to possible future changes in law of course.
OK let’s get back to Jerry and Ginny. Every dollar over that first threshold increases how much your Social Security benefits are taxable by 50 cents, and we didn’t reach the second threshold. SO here we go:
Provisional income is $44,000. That exceeds the first threshold of $32,000 by $12,000. 50 cents on every dollar for $12,000 would be….$6000. This means that Jerry and Ginny would have to claim $6000 of their $30,000 of Social Security benefits.
Had Jerry and Ginny increased their income by one more dollar from here, they would be increasing how much their Social Security benefits got taxed by 85 cents. Now let’s think about this critically for a moment.
Should Jerry decided to pull that dollar out of his IRA account, he would not only have include that dollar in his taxable income and pay tax on it, but he’d also have to pay tax on 85 cents more of his Social Security. Isn’t that almost like being taxed twice on the same dollar? Yes! It sure is. And people in this range of the income spectrum so often do not know that they are subject to this form of double taxation, and that it may be avoided! You know, Valentine’s Day is right around the corner, and what better way to say I love you than a tax-efficient retirement plan?
So what can you do to be the hero and keep more of your Social Security benefit in your own pocket? First, and if you watch my videos with any frequency you know I have a deep affection for having a Roth IRA! Roth IRA withdrawals do not increase your provisional income! What if Jerry had been aware that that extra dollar of IRA withdrawal was going to be taxed AND increase his Social Security taxes? Wouldn’t it have been smart to pull any additional funds that year from his Roth IRA? How about the years prior to claiming Social Security? If his income was in the same basic area, he may have been very wise to convert some of his IRA funds into Roth IRA dollars at that point.
Maybe some of Ginny’s income is from part-time employment. Now thanks to the SECURE Act, if you’re working, you can make IRA contributions at any age. A deductible IRA contribution might reduce your income enough to avoid taxes on Social Security altogether!
Are you charitable inclined and taking minimum required distributions from your IRAs? Consider donating part of that required withdrawal to a charity through a QCD.
There are lots of possible things you can do to lower your provisional income and reduce or eliminate taxes on your Social Security. The first step though is knowing what causes it to be taxable in the first place.
So! Do you have questions for me? Let me know! Come visit me at www.retirementtheory.com or send me an email at firstname.lastname@example.org. Did you click subscribe on this video or follow me on Facebook? I think that you should. You’ll continue to see videos like these on everything retirement planning?
Once again, thank you for joining me. We’ll see you next time!