When it comes to Social Security benefits, most of us don’t think about taxes. But the harsh reality is the Social Security Administration (SSA) estimates that about 56% of beneficiaries will need to pay some amount of taxation on their benefits.
With that in mind, it’s incredibly important to understand how your benefits are taxed so you aren’t dealt a nasty surprise on Tax Day. Let’s break it down.
The Internal Revenue Service (IRS) uses a figure known as combined income to calculate taxes on Social Security. This is more commonly referred to as provisional income.
Fortunately, the formula for provisional income is simple:
Taxable income + Tax-exempt interest + 50% of your Social Security benefit
Let’s define the terms above:
Taxable income could be earnings from a part-time or full-time job or capital gains from sold stocks or other investments. For retirees, taxable income is usually the distributions from their post-tax retirement accounts like a 401k, but all taxable income should be included.
Tax-exempt interest refers to any tax-exempt interest payments from specific types of investments. The most common example would be municipal bonds. If you’re unsure, then you most likely don’t have tax-exempt interest, but it would be wise to consult your accountant.
50% of Social Security benefit is exactly as it sounds. Simply divide your total annual benefit in half.
Add all three together, and you’ll have your annual provisional income.
Social Security tax thresholds
Once you know your provisional income, you’ll need to compare it to the Social Security tax thresholds. Take a look below:
Tax Filing Status
Social Security Taxation
Single or head of household
Up to 50%
Up to 85%
Up to 50%
Up to 85%
A look at how it works
Now that we know how to calculate provisional income and the various taxation thresholds, we can determine how much of a hypothetical Social Security recipient’s benefit will be taxed. Let’s say a married couple takes $35,000 in distributions from their 401(k), plus they’re getting $40,000 in Social Security benefits. They don’t receive any tax-exempt interest.
This means their provisional income would be $35,000 + (50% of $40,000) which equals $55,000. Using the taxation chart above, we know the first $32,000 is completely tax-free.
From there, we can see that 50% of any income over $32,000 and under $44,000 is going to be taxed. It’s important to note that this doesn’t mean that income in that range is taxed at 50%, but rather, half of the income in that range is subject to taxation. In other words, this couple will be paying taxes on $6,000 of their Social Security income within that range (50% of $12,000).
Finally, they made $11,000 over $44,000, which means 85% or $9,350 will be taxed.
Therefore, out of the couple’s total Social Security income of $40,000, only $15,350 is subject to taxation. Once again, this doesn’t mean they’ll be paying $15,350 in taxes, but rather that this is the only portion of their benefit that will be taxed.
2 things to remember
When looking at the provisional income tax formula, you’ll notice the first two parts of the equation are represented dollar for dollar, while only 50% of your Social Security benefit is accounted for. The first logical takeaway is that the higher the percentage of your income comes from Social Security, the lower your taxes are likely to be.
The second, less obvious, takeaway is how incredible post-tax retirement accounts (such as Roth IRAs) are. Because distributions from these accounts are 100% tax-free, they would not be factored in whatsoever to your provisional income, and thus could prevent you from having to pay Social Security taxes.
If you can maximize your Social Security benefit and get a healthy amount of your yearly income from a Roth IRA (or other post-tax account), you’ll pay little or no income tax on your Social Security benefits in your retirement.
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