In our last article, we took a detailed look at Social Security (SS) benefits for divorced spouses. Today, we examine the taxation of SS and other retirement benefits. SS benefits are taxed more favorably than, for example, distributions from an individual retirement account. It’s important to understand how this works so that you and your clients can figure out the most tax efficient way to plan their retirement.
Why are so few talking about things like this, an area in which so many people sincerely need so much help? For one thing, it’s complicated. Frankly, the taxation of SS is way more complicated that it should be. This is the result of decades of government fine-tuning. And that may be why so few—even sophisticated financial professionals— speak about it in detail. They don’t want to talk about something they don’t fully understand.
SS Versus IRA?
Say your client has decided he wants to retire at age 66, and he’s not sure whether he should start collecting from SS or his IRA.
The maximum percentage of SS that can be taxable is 85 percent, so it’s generally going to be less taxable than your client’s IRA. Now let’s try to go through how that percentage is calculated. We’ll keep it simple as possible, but it still requires some government lingo to figure out.
Anyone who receives SS retirement benefits must run through three different calculations to figure out how much of it is taxable. Not to figure out the tax itself, just to figure out the taxable amount. It can be anywhere from 0 percent to, 85 percent.
Start with your client’s adjusted gross income (AGI), modified adjusted gross income (MAGI) and the provisional income (sometimes referred to as “combined income”). AGI includes virtually all income, including W-2, self-employment income, capital gains, investment income and income from a qualified retirement plan and/or IRA. It doesn’t include distributions from a Roth IRA.
MAGI includes the AGI plus tax-exempt interest and foreign earned income. Let’s say your client and spouse have an AGI of $28,250 plus $2,000 of tax-exempt interest. Then, to get to the provisional income, you also need to add 50 percent of the SS benefit received.
This is where many people get confused. Adding 50 percent of the SS benefit doesn’t mean that it’s 50 percent taxable; that’s just the amount that goes into the initial formula. If your client collected SS of $48,000, $24,000 would count toward his provisional income. Thus, the total would $54,250.
With that number, three different calculations are required to determine the taxable amount. The one that produces the lowest amount will be applicable.
Calculation 1. This is the simplest: A maximum of 85 percent of the SS benefit is taxable. That works out to $40,800.
Calculation 2. This calculation requires the use of two threshold amounts, which are $32,000 and $44,000 for married taxpayers.
The amount by which the provisional income exceeds the $32,000 first threshold is taxable at 50 percent until the second threshold of $44,000 is reached. Then, the taxable portion becomes 35 percent of provisional income over the $44,000 second threshold. If you do the math, the amount calculated under the second threshold is $14,713. So it looks like your client’s SS income will be significantly less than 85 percent taxable.
Calculation 3. This requires the use of the same two threshold amounts as used in Calculation 2. It provides that 50 percent of the $48,000 SS benefit is taxable, plus 85 percent of the provisional income over the second threshold of $44,000. This works out to $32,713.
Use Lowest Amount
So, now we have the different calculations: $40,800, $14,713 and $32,713. For your client, the lowest-- the second calculation of $14,713-- would be applicable. This means that approximately 31 percent of their SS benefit will be taxable.
Note that unlike the SS benefit itself, these thresholds aren’t adjusted for inflation. So in effect, anyone collecting SS would be subject to “bracket creep.” In other words, as time goes by, unless legislation changes the thresholds, more and more of your client’s SS income will be taxable.
One interesting observation: for a single individual the threshold amounts are $25,000 (rather than $32,000 for a married couple) and $34,000 (rather than $44,000). That’s not much of a difference. So it could be argued that there’s a “marriage penalty” when it comes to SS benefits.
Tax-Exempt Interest Income
Note that tax-exempt interest income is part of the calculation. It could be argued that in certain situations, if you’re collecting SS, the government is taxing some of your client’s tax-exempt income. Let’s re-examine the previous example, this time assuming that your client didn’t have $2,000 of tax-exempt income. In that case, the portion of the $48,000 SS income that’s taxable would be $13,013. So the $2,000 of tax-exempt income resulted in $1,700 of additional SS income being taxed.
Again, remember that this isn’t the amount of tax due; it’s merely the increase in the resulting taxable income. And these numbers will vary in every situation. If your client had W-2 income or IRA distributions of $100,000, the tax-exempt income would have no impact at all.
Finally, we need to address what some refer to as the “tax torpedo.” It occurs particularly after age 70½, when 401(k)s and IRAs are subject to minimum distribution rules. In essence, the tax torpedo means that those taxable distributions can have the additional effect of creating more taxable income from SS. It’s commonly believed that retirees are likely to be in a lower tax bracket when they stop working. That may not always be the case.
With this as background, in our next column we will take a more detailed look at how best to plan your client’s after-tax retirement income with a variety of financial products.