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Straightforward Answer
As a Lakewood, CO financial planner specializing in retirement planning, I get this question a lot. The most straightforward answer is yes: Social Security income is generally partially taxable at the federal level. The worst-case scenario is that 85% of your benefits will be taxable, but that is not a usual situation.
Calculating Your Social Security Income Tax
For those like me, who are analytical and like numbers, below are the two steps you need to follow to calculate how much your social security benefit will be taxable. In the end, the final taxable amount is the lower amount of either Step 1 or Step 2.
Step 1. Determining provisional income as follows:
One-half of social security benefits, plus
All other income, including tax-exempt interest.
A taxpayer must include in income a portion of social security benefits received when provisional income exceeds a specified base amount.
Maximum Limits
As a side note, the percentage of benefits a taxpayer includes in income is limited to 50% when provisional income exceeds the lower base amount and 85% when above the upper base amount. We will come back to this in the example below.
A taxpayer with provisional income below the lower base amount excludes all social security benefits from income.
Example
A married taxpayer receives $20,000 in social security benefits. The taxpayer has $10,000 in tax-free municipal bond interest and $30,000 in taxable IRA withdrawals during the year.
In this example, the total provisional income is $50,000, exceeding the upper threshold for married filing joint (MFJ) status in exhibit 1A. For this taxpayer, the maximum taxable portion of social security benefits to include in income is 85% of the social security benefits, or $17,000 ($20,000k x 85%). But wait, this amount is further limited.
Provisional Income Base Amount. Exhibit 1A.
Step 2: Allocate provisional income to each tax bracket based on MFJ filing status.
The Calculation
Allocate provisional income based on filling status.
Multiply the amount of provisional income that is between the lower and upper base amount by 50%, and the amount above the upper base amount by 85%, and then add together.
The taxable portion of social security benefits to include in income is the lower of this amount, or that maximum limit discussed earlier.
Example (continued): The taxpayer in this example uses the Married Filing Joint (MJF) status. Apportion the amount of provision income above $44,000 (upper base amount) to the 85% bracket, and any remaining that is above $32,000 (lower base amount) to the 50% bracket. Now compare provisional income to the brackets to determine the taxable amount of social security benefits.
The amount to include in income is $11,100, as this is lower than the $17,000 maximum amount calculated earlier.
Next Steps
Creating income from your investment portfolio in a tax-smart way can lower the overall amount of taxes you pay on your social security benefits. Give me a call if you would like to discuss your situation further.
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