How Are Benefits Taxed? Provisional Income.

The taxability of social security benefits depends on your provisional income. This is your total income from all taxable sources plus tax-exempt interest (that is right, even tax free municipal bond interest!).  You also need to include ½ of your social security income. Essentially, your total income is the net amount of income reported on the front of your 1040 plus half your social security benefit. If this total is more than $25,000 (individuals) or $32,000 (families) then 50% of the excess is included in income. For amounts over $34,000 (individuals) and $44,000 (families) 85% of the excess is included. For filers reaching the 85% mark there are additional calculations used until a maximum of 85% of all social security is taxable. 

For example, if a couple has income of $50,000 and social security benefits of $20,000 then their provisional income is $60,000. $50,000 plus ½ of their social security benefit. Half of the amount from $32,000 to $44,000 ($12,000 x 50% = $6,000) plus 85% of the surplus over $44,000 ($60,000 – $44,000 = $16,000 x 85% = $13,600) would potentially be added to their taxable income for a total of $19,600.  However, there is a cap of 85% applied to the social security earnings for a maximum (in this case) of $17,000. Their AGI is increased by the $17,000 from $50,000 to $67,000. 

At varying income levels, the formula will be applied differently but the concept is always the same: as income increases, taxation of social security increases.

Marginal Tax Rates

The formula used to determine the amount of your social security subject to taxes is based on income; therefore, the result is that the net calculation serves like an additional tax as social security is phased in. 

Assume a married couple has income of $40,000 and social security benefits of $20,000. $11,100 of their benefit is taxable. Half of the amount between $32,000 and $44,000 ($6,000) and 85% of the amount over $44,000 ($5,100). Their taxable income is $51,100. Now assume that the couple takes $10,000 worth of distributions from their IRA. Even though they only took out an additional $10,000 they effectively add $15,900 to their taxable income. Half of the amount from $32,000 to $44,000 ($6,000) and 85% of the amount over $44,000 ($13,600) capped at $17,000. 

Importantly, without the $10,000 distribution the couple’s taxes would be $6,732.50 or 13.18% effectively. Increasing the income by $10,000 adds $2,385 in taxes. Put differently, the distribution is taxed at an effective rate of 23.85% – because of the inclusion of additional social security! For married couples this tax bubble exists in the 15% bracket and below. However, for single filers (because of the lower limits) the bubble exists in the 15% and 25% brackets. An individual can see a jump from 25% to 46% effectively!

It is rare for income and social security benefits to align such that a client would see that jump. It is still important to realize how social security benefits can result in a surprisingly higher effective tax rate. 

Planning Strategies

While understanding how social security benefits can change your tax obligation can help you know what to expect when you file. Although, in practice, there is often little that can be done to reduce that exposure once social security has been claimed.

The first step is making sure these marginal tax rates are being tracked in your financial plan. Most online tools available to the public (and many tools used by advisors!) are not sophisticated enough to adjust accordingly or even estimate taxes. Gainplan uses state of the art software to project benefits and estimate tax impact from different income strategies.

Additionally, once benefits are being tracked accurately, the best approach is to control income prior to claiming social security benefits. A Roth conversion strategy in the years following retirement but prior to receiving social security creates a more flexible income pool to tap in later years. Ideally, conversions are done up to, but not exceeding, the lower (applicable) marginal bracket. The whole point of a conversion is to make the transfer while tax rates are lower than they will be in the future. 

Of course, there are other methods for managing social security marginal rates, ranging from asset allocation strategies to income deferral. Ultimately, the effectiveness of each strategy depends on the client’s unique situation and analysis needs to be done by a qualified professional.

This commentary on this website reflects the personal opinions, viewpoints and analyses of the Gainplan LLC employees providing such comments, and should not be regarded as a description of advisory services provided by Gainplan LLC or performance returns of any Gainplan LLC Investments client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Gainplan LLC manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.