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Figuring Taxes on Social Security Benefits

by Julian Block

Figuring Taxes On Social Security Benefits Splash image

Americans often dream about a simplification of the Byzantine Internal Revenue Code, only to awaken and find the tax laws becoming more complicated.

The rules for Social Security benefits are especially convoluted and confusing. Although most Social Security recipients escape income taxes completely on all of their benefits, middle- and upper-income level retirees have to count up to 85% of their benefits as reportable income.

Gift of the MAGI

Taxes are triggered for Social Security recipients when their MAGI exceeds specified amounts. MAGI is an acronym for modified adjusted gross income, which in most instances is essentially the same amount as adjusted gross income.

To calculate whether MAGI surpasses the tax-triggering thresholds, retirees must consider income from various sources such as: salaries, pensions, dividends, capital gains, rents, Roth conversions (money moved out of traditional IRAs and into Roth accounts), and required minimum distributions RMDs starting at age 70½ from traditional IRAs, 401(k)s, and other retirement plans.

The wide-ranging MAGI tally for Social Security benefits also includes whatever retirees receive as tax-exempt interest from municipal bonds (obligations issued by state and local governments) or from muni bond funds, as well as 50% of Social Security benefits. Table 1 shows how to calculate MAGI.

Table 1. Calculating Modified Adjusted Gross Income (MAGI)

A   Social Security Benefits (annual total)

B   Calculate Half of Line A

C   Adjusted Gross Income (pensions, wages, dividends, Roth conversions, etc.)

D   Tax-Exempt Interest Income (e.g., interest from municipal bonds)

E   Add Lines B, C, D to Determine MAGI

Take, for example, a married couple who have Social Security benefits of $28,000, adjusted gross income of $31,000, and tax-exempt interest of $5,000 for a total of $64,000. Their MAGI is $50,000 (see Table 2).

Table 2. Example of MAGI Calculations

A   Social Security Benefits                                                          $28,000

B   Half of Social Security Benefits                                             $14,000

C   Adjusted Gross Income                                                          $31,000

D   Tax-Exempt Interest Income                                                    $5,000

E   MAGI (total of lines B, C and D)                                             $50,000

 

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The Internal Revenue Service uses a three-tiered threshold to determine the size of its bite on benefits. If MAGI is less than $25,000 for single taxpayers ($32,000 for married couples filing jointly), then Social Security benefits are not taxed. If MAGI is between $25,000 and $34,000 for singles (between $32,000 and $44,000 for couples), up to 50% of Social Security benefits are taxed. And if MAGI tops $34,000 for singles and $44,000 for joint filers, up to 85% of benefits are taxed (Table 3). Special rules apply to married couples who file separate returns. More on that later.

Table 3. Thresholds for Taxing of Social Security Benefits

Modified Adjusted Gross Income MAGI                                                                                       Benefits Taxed__

< $25,000 Single ($32,000 Married)                                                                                                  None Taxed

$25,000 to $34,000 Single ($32,000 to $44,000 Married)                                                               Up to 50%

> $34,000 Single ($44,000 Married)                                                                                                    Up to 85%

The MAGI numbers are significant for those receiving Social Security benefits because the greater the incomes they derive from sources other than Social Security, the greater the portions of their benefits that become taxable. Once beyond the top threshold, each additional $100 of income from pensions or investments can cause an additional $85 of benefits to be taxed.

Suppose Patrick and Nadine Vennebush have combined salaries and pensions of $100,000 per year. They are able to claim enough deductions (dependency exemptions, real estate taxes, mortgage interest, etc.) to fall into the 15% federal tax bracket. (For couples in 2010, this bracket covers taxable income between $16,750 and $68,000.) Their MAGI puts them slightly below the threshold for the highest MAGI tier.

The Vennebushes need additional funds to cover unanticipated expenses. Without considering the tax consequences beforehand, Patrick and Nadine opt to take $3,000 from a traditional IRA, a withdrawal that is in addition to any required minimum distribution RMD they conceivably might have taken. The $3,000 pushes their total income above the threshold for the highest MAGI tier (they were below the threshold prior to the withdrawal), thereby bumping another $2,550 (85% of $3,000) of benefits into taxable terrain.

That means the $3,000 withdrawal increases their income taxes by $833: the sum of $450 (15% of the $3,000 IRA withdrawal), plus $383 (15% of the $2,550 worth of Social Security benefits). Consequently, their effective tax rate on the withdrawal nearly doubles to 27.8%. Worse still, the federal tab is before any applicable state income taxes.

Most of the time, I encourage investors like the Vennebushes to defer taking distributions from their retirement plans for as long as possible, using only the RMD, whenever feasible, as a way of delaying the inevitable tax bite. This tactic becomes even more advantageous when there is the potential for higher taxes on a portion of Social Security benefits.

A savvier strategy that leaves MAGI unchanged would be for the Vennebushes to take a non-taxable $3,000 from a place like a savings account and then repay the “loan.”

Alternatively, the couple could realize paper losses on investments in individual stocks, bonds or mutual fund shares to offset capital gains. They cannot offset capital losses against “qualifying dividends,” which is IRS lingo for dividends that are taxed at rates of 15% or 0%; it makes no difference that those rates are the same as those for capital gains.

What if the Vennebushes have no gains to offset or if losses exceed gains? They can use their losses to offset as much as $3,000 of ordinary income, such as salaries, business profits, pensions, and interest, thereby reducing MAGI.

What if losses aggregate more than $3,000? Not to worry. They can carry forward unused losses indefinitely to offset future income, should that prove necessary. But the couple’s planning can come undone if they ignore or are unaware of the rules for what the IRS characterizes as a wash sale. They forfeit a current deduction for their loss if they step back into the same or a “substantially identical” investment within a period that spans from 30 days before to 30 days after the sale, a transaction that is called a “wash sale.”

Considerations for Couples Who File Separately

Yet another complication is a much-misunderstood restriction for couples who opt to file separate returns. The general rule is that their threshold for exemption from taxes drops from $32,000 to $0. To qualify for relief from the general rule, the spouses must not reside together at any time during the taxable year. Stated another way, a couple who lived together, even for just a day, and file separately are not allowed the base exemption amount of $25,000 each. All of their Social Security benefits count as reportable income.

This trap snared Thomas W. McAdams, a retired Army colonel. Tom and his wife Norma stayed married but lived apart: She lived in the home they owned in Boise, Idaho, while for many years he lived most of the time in Ninilchik, Alaska, and other locales far from Boise. The estranged spouses listed themselves on their 1040s as “married filing separately.”

The IRS computers bounced Tom’s return. During the audit, Tom inadvertently divulged that he stayed in Norma’s dwelling for more than 30 days during the year at issue, though he always slept in a separate bedroom. That admission led the U.S. Tax Court to agree with the IRS that Tom did not, as the law specifies, “live apart” from his wife “at all times during the taxable year.” The 2002 decision deconstructed living apart to only mean living in separate residences, not separate areas of the same residence. It held that his visits disqualified him for the $25,000 exemption. Hence, his Social Security benefits did not sidestep taxes.

A couple could avoid this if they divorced and then lived together out of wedlock. A beleaguered IRS readily concedes that as long as their unaltered arrangement remains unaltered, each spouse would be entitled to use the base amount of $25,000 for a single person.

Advantages of Separate Returns

The Tax Court’s analysis underscores that a married couple who live together and file separate returns must resign themselves to the forfeiture of their threshold. Consequently, why would it be worthwhile for retirees receiving benefits to consider skipping joint returns?

Actually, there are a number of sensible reasons. The biggest, from a monetary standpoint, is that submitting separate 1040s can lessen amounts lost to taxes. Take the not-uncommon situation where one spouse has a relatively modest adjusted gross income, AGI, and is able to claim sizable write-offs on Schedule A of the 1040 form for three categories of itemized deductions that are limited by a percentage of AGI. The possibilities are: uninsured medical expenses, allowable just for the part that exceeds 7.5% of AGI; uninsured casualty and theft losses, allowable only when such losses exceed $500 ($100 for 2008 and earlier years) for each casualty or theft, plus 10% of AGI, unless they occur in places determined to be disaster areas eligible for federal assistance; and miscellaneous expenses, such as fees for preparation of 1040 forms or advice on tax and investment strategies, allowable just for the portion above 2% of AGI. Claiming those kinds of expenditures on a separate return that reports less AGI than a joint return means that more of them become allowable.

It should be noted that signing a joint return makes each spouse responsible for the total tax liability on the return—and for any increase in that liability due to the other spouse’s underreporting of income or embellishment of deductions and credits. The law explicitly allows the government to keep both spouses tied to their old joint tax liabilities long after every other bond that joined them has been dissolved. The IRS could not care less that one spouse has since died or that the extra taxes are attributable to the deceased spouse’s business or income. Moreover, it is immaterial that a divorce decree specifies that one spouse assumes complete responsibility for previous joint returns.

Fortunately, the joint-liability regulations are not inflexible. Inserted into the Internal Revenue Code are several relief provisions that let individuals cleanly and permanently sever themselves from all tax wrongdoings of their former or estranged spouses. But establishing eligibility for relief frequently requires the high-priced help of tax professionals, expenditures that are avoidable by the submission of separate returns.

Further Rules

Roth IRA Conversions

Because conversion income counts as reportable income, a Roth IRA conversion could increase MAGI by enough to cause otherwise tax-free Social Security benefits to become partially taxable. But as there are no taxes on subsequent Roth withdrawals, they will not expose benefits to taxation.

Put another way, you can incur taxes on Social Security benefits because of taxable transfers from traditional IRAs to Roth accounts, but not because of later Roth removals.

Tax-Exempt Interest

Moving money into tax-exempt investments can significantly lower the total tax bill for retirees, just as it does for others. But that maneuver will not diminish the taxes paid on Social Security benefits by retirees who also receive tax-exempt interest.

As mentioned earlier, tax-free interest must be added to funds received from pensions and other sources to determine MAGI. So tax-exempt interest can cause income to exceed the $25,000 (single) and $32,000 (married) base amounts at which benefits begin to be taxed.

State Income Tax Returns

Retirees required to declare Social Security benefits on the 1040 forms should check the rules of the states in which they have to file returns. Social Security benefits often escape state income taxes.

In California and New York, for example, Social Security benefits are a subtraction on page one of the return when computing taxable income.

The Effect of Ignoring Inflation

The tax-generating thresholds of $25,000 or $32,000 are not indexed—that is, adjusted upward annually to take into account the effect of inflation—whereas the law authorizes indexing for tax brackets, dependency exemptions and the standard deduction amounts for individuals who choose not to itemize their spending for write-offs like mortgage interest. Accordingly, persistent inflation at even its present low levels assures the IRS of a growing share in the Social Security benefits eventually received by many of today’s younger workers.

This lack of upward adjustments effectively creates a golden parachute for Uncle Sam. Higher tax revenues are generated from workers who retire with fully taxed employer-sponsored pensions (a perk enjoyed by a steadily decreasing number of individuals) or traditional IRAs and supplement their Social Security and pensions with withdrawals of money that they conscientiously socked away for their old age in 401(k)s or IRAs, likewise fully taxed, as is income received from other savings and investment arrangements.

Still, taxation of Social Security benefits should not stop workers from accumulating funds in tax-deferred retirement plans. They will remain a worthwhile option, particularly because of continued concern that the need to raise revenues (government-speak for increase taxes) to offset budget deficits will compel Congress again to address the unpleasant question of how to really keep the Social Security system solvent.

This article is excerpted from “Year-Round Tax Savings,” available at www.julianblocktaxexpert.com.

Julian Block is an attorney and author based in Larchmont, New York. For information about his books, visit www.julianblocktaxexpert.com.


Discussion

Martin from GA posted over 3 years ago:

This is an eye opener! But since when did "tax-exempt" income become taxable!


Leo from DE posted over 3 years ago:

good info.


Richard from GA posted over 3 years ago:

Martin, is tax exempt interest income taxable or just used in calculating taxation of SS Benefits?


Mark from OH posted over 3 years ago:

I understand that MRD from IRA's are taxable,
but how do they justify claiming it is additional income. It amounts to a transfer
from one account to another. You have no more
after the distribution than you had before.


Robert from VA posted over 3 years ago:

Do dividends earned by investments in a Roth IRA account get figured into MAGI?


Dick from VT posted over 3 years ago:

a huge penalty for being married. Everyone of you should be letting your senators and congressman know that married couples should receive twice the single persons 25,000. $50,000 whould be a lot fairer than $32,000. Talk to your church as the IRS is telling you to get divorced.

Just so you know capital gains are not surposed to be taxed if you are in the 15% brackett. Guess again they are included in MAGI and make more of your social security taxable.


Fred from MI posted over 3 years ago:

I will use distributions from my traditional IRA to supplement Social Security income every other year. That way, I am taxed on social security only every other year. I would like to maximize those withdrawls because I believe that IRA's will be taxed in the future, contrary to the advice of "professionals". Already, the Michigan governor is planning to eliminate the state tax breaks for IRA's.


Ronald from NJ posted over 3 years ago:

get rid of the marriage penalty & the politicians who dont correct this dilemma.


David from TX posted over 3 years ago:

Did I miss this something? If one takes Social Security benefits at full retirement age then there is no limit to how much one can earn, and therefore no theshold amount for a taxable liability. Is this not true?


Thomas from TX posted over 3 years ago:

Mr. Bock has written an excellent article. It is this kind of information that makes membership in AAII so useful.

Dick from Vermont cites the negative aspect of recognizing long term capital gains, i.e., it is included in the MAGI, but for those lucky enough to be in the 10 percent or 15 percent tax bracket and who have unrealized long term capital gains in taxable accounts, no Federal income tax is due on these gains if realized in 2011 or 2012. These gains can be lawfully excluded from taxable income thus potentially resulting in negative net taxable income i.e., no tax due. I plan to harvest these gains to the extent I can and still keep taxable income within the 15 percent bracket. The realized long term gains and qualified dividends, when subtracted from taxable income, potentially can result in a negative taxable income, i.e. no tax due. The realized gains can be held as cash to cover future needs with little or no future tax due or re-invested. Future taxes on new gains (or dividends) will probably be unavoidable but at least the tax will be less than doing nothing during the two tax years cited.


Marion from MO posted over 2 years ago:

Why should married couples get twice the deduction. We still pay the same utility and housing costs as married couples. Stop the discrimination against us. You will someday be in our shoes.


Terry from AZ posted over 2 years ago:

There is an addition issue to consider than Social Security. MAGI is also use to determine Medicare premiums. If MAGI for a married couple is between $170,000 and $214,000, then Medicare premiums increase $40 per month and Part D premiums increase $11.60. If MAGI is higher, then the premium increase is greater. This should be considered by many people when calculating a Roth Conversion.


Norman from WA posted over 2 years ago:

The killer is the atrocious marginal tax rate that goes on as one say withdraws more and more taxable IRA as you step through the beginning of the taxing of SS until you get to taxing 85% of SS.

The initial marginal tax rate starts at 15%, then moves to 27.75% then just before you get to the 85% of SS the marginal rate jumps to 48%, then after hitting the max taxable 85%, the marginal tax rate moves to 26%.

This calculation was performed using TAXACT software.

Interesting how the average pensioner with forced RMD can easily fall into the high marginal tax rate. At the worst point almost half of every dollar you withdraw goes for taxes.

The guys that wrote that law knew exactly how to stick it to us.


James Mcmurray from CA posted about 1 year ago:

Helpful article...85% of my S.S. benfit has been taxed. I'll go through my records to see if I can reduce this in the future. Thanks Jim


Gustavo Mellander from FL posted about 1 year ago:

Clearly this good article is outdated by more than a year.
Will we be seeing an update especially given the "cliff" changes made in January 2013?
Thanks!


Dennis Berthold from TX posted about 1 year ago:

Excellent article. Thank you Charles Rothblut for reposting the link in your latest email. I now realize that, in our upper income bracket, there's little we can do to reduce taxes, and will focus more on increasing qualified dividends. A good reality check!


S Mahadevan from MI posted about 1 year ago:

For people who can do , donate all the SSI payments to your favorite charity. This way the IRS does not get what you have paid into SSI.


W Newport from IN posted about 1 year ago:

MAGI is also used to calculate Medicare premiums driving up health care premiums for middle income taxpayers.


Stephen Golder from MA posted about 1 year ago:

The older you get, the more you realize how deceitful and corrupt Congress is. Unless you are poor, those years of payroll deductions are just theft and redistribution of my money to the poor.


Tom Claytor from NM posted about 1 year ago:

Don't you just love those pols that want to cut SS and raise the retirement age? Stick it to those weenies, next election.


Jon Hicks from OR posted about 1 year ago:

I have a couple of questions.
1. If a couples MAGI is $44,000 is 1/2 of their Social Security taxed at 50% or all of their Social Security?

2. If a couples MAGI is $44,001, is all their Social Security taxed at 85% because their MAGI is one dollar over the $44,000 limit?


Victor Bradford from CO posted 24 days ago:

Thanks for the article.
For years, we have often been told delaying social security will give us an extra 8% per year up to age 70, and that actuarial tables tell us it doesn't matter when you collect benefits because the expected gross lifetime payout is the same.
This article suggests those whose income is above the taxable threshold could get considerably less than 8%, because that 8% will be taxed at your ordinary rates. You could even be pushed into a higher Medicare level, as well.
If your income goes over the threshold, the extra income you get from delaying your benefits will be taxable at your ordinary income level. If this is the case, you may be better off collecting benefits at 66 (or even earlier) rather than delaying until age 70. Sometimes, less is more, and your lifetime after-tax income, based on actuarial tables, might be higher if you decide to receive benefits earlier.


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