Taxation of Social Security Benefits can be a tricky subject. Prior to 1984, benefits were not taxable and for many retirees today, that is still the case. But is it the case for you? And is there anything you can do about it?

If you’re retired and you receive no other income than Social Security benefits, then your benefits are not considered taxable income. By no other income, that means no wages, rents, dividends, interest, gambling winnings, you name it…anything that gets counted as income on your tax return. It even includes municipal bond interest, which is usually not taxed at the Federal level.

So what if you do have other income? Up to 85% of your benefits could be included as taxable income. To make sure there is no confusion about this, that doesn’t mean that 85% of your benefits will be lost to taxes. It means that 85% of your benefits will be included as taxable income and will be taxed based on your tax rate.
 

What the IRS does is calculate what they call Combined Income. They add half of your benefits plus all your other income to arrive at this number. Then they compare that total to a few other numbers to determine how much of the benefits are taxable. That first number is $32,000. If you are married filing jointly, your combined income can go up to $32,000 without any of your benefits being taxable. Once you go over that amount, each dollar of combined income causes 50 cents of benefits to become taxable. So if your combined income is $33,000, you are over the limit by $1,000. Which means that $500 of your benefits are taxable.

Now if your combined income is over $44,000, the ratio switches. Above $44,000, each dollar of combined income causes 85 cents of benefits to become taxable. The higher your go, the more of your benefits that will be taxed. It is limited, though, to a total of 85% of your benefits being counted as income on your taxes. (Just to note, if you are Single, the same concept applies but the income levels the IRS looks at are lower.)

So as you can see, if you didn’t know about this, you could be in for a surprise when it’s time to file your taxes. But there’s actually more to it than that. That’s because, with good planning, you may have some options to reduce your total taxes over time by controlling when you recognize certain income items and when you start benefits.

For example, here are a few things you can consider that might reduce your total amount of taxes paid over the years. First, don’t collect benefits while you’re still working if it will cause benefits to be taxable. If you can live off of your work income or other sources, it might make sense to hold off on collecting benefits until after you’ve stopped working. You may avoid paying taxes on your benefits and you also lock in a higher monthly benefit by doing so.

Another option if you don’t need the benefits to cover current expenses is if you have saved up a decent amount in 401(k) or IRA accounts over the years. If you stop working and have little other current income, you could make Roth conversions of your retirement accounts. You pay tax up front to do so, but you can take withdrawals later on with no tax. A key point here is that converting to Roth accounts will reduce the required minimum distributions you have to make starting at age 70 and a half. Those distributions could otherwise contribute to your benefits becoming taxable.

A third item to consider is income lumping. The idea of lumping tax items is more common with deductions, but it can also make sense with income in some circumstances. For example, let’s assume you need to sell stocks from your portfolio to cover some of your expenses each year and that those stocks have some fairly large capital gains built in. If those gains are causing more of your benefits to become taxable, you might want to sell, say, two years worth of expenses this year and not sell any stock next year. It’s possible that this reduces the total amount of benefits that are taxed over the two-year period, resulting in fewer taxes you have to pay in total. Modus Advisors works with a client’s tax advisor to determine whether such strategies may make sense.
 

Note: This blog article is one of a series related to Social Security Benefits. Please also review the companion video (or just the slideshow) for a more expansive review.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.