As the baby boomers become eligible for Social Security benefits, many are confused on how Social Security is taxed on their return.

Last week, we talked about when to take Social Security Benefits. If you missed it, you can go back and listen to it on our website at www.hawkinsashcpas.com. This week, I want to talk about the tax effects of taking Social Security. Click the orange button to listen to this podcast episode.

Script

WHEN ARE SOCIAL SECURITY BENEFITS TAXABLE TO ME?

Your Social Security Benefits will be taxable if your total income for a married couple is over $32,000 or for a single or head-of-household, $25,000. Now that $32,000 is made up of all of your income, i.e. your W-2 income, your business income, your interest and dividends, IRA’s and pensions, things like that, plus any tax exempt income, plus one-half of the Social Security benefit you actually received. Therefore, how much of your Social Security becomes taxable is based off of a sliding scale. It can be anywhere from 0% taxable up to 85% taxable. It is zero for married persons who file separately and lived together at any time during the year.

CAN YOU GIVE ME SOME EXAMPLES OF HOW THE SCALE WORKS?

Say we have a married couple and their Social Security benefits each year are $40,000, and they have other income totaling $12,000. When we do the math, we have $12,000 of income, plus half of the $40,000 of Social Security, they now have $32,000 worth of income. Based on our previous discussion, if you have $32,000 of income or below, that Social Security is not taxable. But let’s add something to that scenario. Let’s say that you have a capital gain or you decide to take some money out of an IRA to buy a car or an RV, or take a vacation, something like that. Let’s say you add just $10,000 more of income to the scenario we just talked about. By adding that $10,000 more, your taxable income is actually going to increase by $15,000, because you pick up the $10,000 of extra income and $5,000 of your Social Security now becomes taxable. Therefore, a $10,000 withdrawal actually increases it by $15,000. If we go up a little higher in the bracket and you decide to take $30,000 extra out. That $30,000 increases your taxable income by $51,000, or an extra $21,000. If we take it to the extreme and you take an extra $45,000 out of an IRA or have capital gain income, etc., it costs you $80,000 of additional income because $35,000 of your Social Security will become taxable, which is essentially 85% of the $40,000 benefit that you received.

WHEN CAN PEOPLE GET CAUGHT OFF GUARD AS TO THE NEGATIVE TAX CONSEQUENCES

  • First year that you take Social Security
  • Taking Social Security and continuing to work or your spouse works
  • Get married after receiving Social Security
  • Taking out lump sums from IRAs

In summary, we find that a lot of people get caught off guard that first year they start taking Social Security. For most of us, we have gone through our working years and we have received W-2 income and on that W-2 our employers take off federal and state taxes. Well, people can get caught out because for Social Security, unless you tell them to withhold taxes, they won’t. Therefore, now you have all of this extra income on your return, there was no withholding against it and so now you have to pay that tax when you file your tax return on April 15. The other thing that we find is that if people take Social Security while their spouse continues to work, because like we saw in the examples above, if your spouse has any sort of income, a lot of your Social Security benefits are going to become taxable once again. If you don’t have any withholding against that Social Security income, it’s going to cause you to have tax at the end of the year. The other thing is that when people get married later in life and maybe they were both receiving Social Security for the last couple of years and their income wasn’t that high so none of their Social Security was taxable, but now they get married and their income is above that $32,000 threshold, now some of their Social Security becomes taxable, so they get caught off guard for that.

WHAT CAN BE DONE TO DECREASE THE IMPACT OR AT LEAST MAKE IT EASIER COME TAX TIME?

  • Take distributions out in stages rather than lump sums.
  • Take out enough each year to maximize a tax bracket.
  • Set up withholding on the Social Security payments.

Although many people know that Social Security benefits can be taxable, they still get caught off guard when tax time comes. Being aware of how Social Security is taxed can keep those surprises to a minimum.

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Corenne Gutierrez
I joined Hawkins Ash CPAs in 2011. As the Firm's marketing manager, I develop and deploy strategic marketing and communications plans to fulfill the marketing goals of the Firm as a whole, each office and business line.

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