The Ins and Outs of Social Security Benefits and Taxes

Note: This article is part of Morningstar's February 2016 Tax Relief Week special report.

It's an unpleasant fact of life: The taxman can take a bite out of your Social Security benefits.

The federal tax formula was crafted to initially target higher-income households, but the share of benefits taxed has risen over the years, because the income thresholds for taxation aren't indexed for inflation or real income growth. Meanwhile, there are big variations in how states tax benefits. As a result, a solid retirement plan should include an understanding of whether you will pay taxes on Social Security benefits, how much you'll pay, and how that will impact your overall tax picture in retirement. In some cases, savvy planning can lessen the tax bite.

Why Benefits Are Taxed Benefits were first taxed in 1984 as part of a comprehensive Social Security reform package signed into law the previous year aimed at stabilizing the program's finances. The most important part of that reform was the gradual lifting of retirement ages, but taxes collected on benefits played a supporting role. Taxes on benefits go to the Social Security Trust Fund and contribute to its solvency. Taxation of benefits for higher-income households was expanded in 1994, with the additional revenue dedicated to shoring up Medicare. Taken together, $51 billion in tax receipts went to the trust funds of the two programs in 2014, according to the Congressional Budget Office (CBO).

About half of all Social Security beneficiaries owed some amount of income tax on their benefits in 2014, according to the CBO, but the burden falls mainly on higher-income households. Beneficiaries with incomes below $40,000 owed less than 0.5% of benefits in taxes in 2014, while those earning more than $100,000 owed 21%.

However, the CBO estimates that taxes paid will rise from 6.5% of total benefits in 2014 to more than 8% by 2024, and more than 9% by 2039. That is due to the lack of indexation of the income thresholds.

The formula's targeting of higher-income households makes it the opposite of the payroll tax, which is paid by workers and employers alike at a flat rate of 6.2% of wages up to $118,500. "The payroll tax is regressive, but the benefit tax is progressive," says Andy Landis, a retirement educator and author of Social Security, The Inside Story.

How Benefits Are Taxed The formula used to determine the tax is unique. First, you determine a figure Social Security calls "combined income" (also sometimes called "provisional income"). This is equal to your adjusted gross income plus nontaxable interest plus 50% of your Social Security.

No taxes are paid by beneficiaries with combined income equal to or below $25,000 for single filers and $32,000 for married filers. (If that sounds like a marriage penalty, that's because it is one. On the other hand, married couples can access valuable spousal and survivor benefits not available to single people. So, let's call that one a wash.)

Beneficiaries in the next tier of income--$34,000 for single filers and $44,000 for married filers--pay taxes on up to 50% of their benefits. Beneficiaries with income above those levels pay taxes on up to 85% of benefits.

Michael Kitces, director of research for Maryland-based Pinnacle Advisory Group, offers this example:

Jeremy and Martha have an AGI of $28,000 (and no tax-exempt or foreign income), and receive combined Social Security benefits of $14,000. As a result, their provisional income is $28,000 + $7,000 (half of Social Security benefits) = $35,000, which is $3,000 above the $32,000 threshold. This means that 50% x $3,000 = $1,500 of their Social Security benefits are subject to taxation, which ultimately increases their AGI to $28,000 + $1,500 = $29,500.

Beneficiaries receive IRS Form SSA-1099 from the IRS during tax season, which reports your net benefit subject to tax (after Part B Medicare premiums have been subtracted).

Income is reported on the 1040 or 1040a forms (Form 1040EZ cannot be used). The popular tax-filing software programs also have the capacity to handle Social Security income. You can also ask the Social Security Administration to withhold taxes when you file for benefits at rates of 7%, 10%, 15% or 25%. "It's just a matter of convenience--not a requirement," says Greg Rosica, a tax partner at Ernst & Young and contributing author to the EY Tax Guide 2016.

State policy on taxation of benefits varies. Twenty-nine states (including the District of Columbia) that have a broad-based income tax exempt all Social Security from tax, according to a tally by the Institute on Taxation and Economic Policy. Seven states tax some Social Security benefits but provide an exemption that is more generous than what is available at the federal level. Six states tax Social Security benefits using the federal formula.

The Earnings Test One point of confusion about taxes and Social Security swirls around the earnings test. This is the formula that withholds benefits for people who have claimed benefits below their full retirement age (FRA) and still earn income from work. Although some people think of the earning test as a tax, the withheld amounts actually are added back into your benefit after you reach FRA.

In these cases, Social Security withholds one dollar in benefits for every two dollars of earnings in excess of an exempt amount of income. For workers who reach FRA after 2016, the exempt amount is $15,720. For workers who reach FRA in 2016, the annual exempt amount is $41,880--a limit that applies only to earnings made in months prior to the month of NRA (normal retirement age) attainment. For that higher limit, one dollar of every three dollars in benefit is withheld.

After FRA, Social Security recalculates your benefit to give credit for the withheld payments. The payments are added back in during the year after a beneficiary reaches FRA, according to the Social Security Administration.

Minimizing the Bite There isn't much you can do to minimize taxation of Social Security--and most experts don't consider it important enough to drive overall retirement-plan strategies. "Most of the people we work with understand it--they would prefer not to pay it, but it is what it is," says Rosica. "Some planning can be done around it, but it can be challenging because planning for this might cause other things not to work as well."

Still, the taxation of benefits has the effect of boosting marginal tax rates--significantly in some cases. A beneficiary otherwise in a 15% tax bracket could face marginal rates of 22.5% to 27.75%, calculates Kitces; those in the 25% bracket could see marginal tax rates as high as 46.25%.

"It just makes your tax bracket higher than you might have otherwise thought," he says.

The bracket-boosting effect kicks in while Social Security taxes are phasing in--starting at $25,000; after the maximum amount of Social Security (85%) has been included in income, the rates start behaving normally again. Managing the timing on drawing income from tax-deferred accounts can help, Kitces says. "When do I take money out? Am I doing a Roth conversion? Do I want to invest in a nonqualified deferred annuity as a way to defer income?"

The Roth calculations, in particular, change when Social Security tax is considered, he says. "The classic rule is to put an available dollar into an IRA when you still are working, if you think your tax bracket will be lower in retirement," he says. "But if I'm in a 15% bracket and it's actually going to be over 27% in retirement, I should pay my tax bill now and fund the Roth."

An every-other-year strategy for taking tax-deferred income also can help, says Rosica. "If I'm in that $25,000 to $50,000 income level, there probably are ways to arrange your affairs to get better outcomes," he says.

Kitces adds that, in some cases, the best alternating-year strategy is to add more income in the high-income year, after the 85% cap has been hit, to avoid falling in the $25,000 to $50,000 range in the following year.

"This is somewhat counterintuitive for most people, but it's actually a big opportunity," he says. "For instance, rather than having annual income of $50,000, you really might be better off by doing $75,000 in one year, then $25,000 the following year. Most people are trained to think that boosting income to $75,000 is 'higher' income and causes more taxes when, in reality, it can result in less!"

Mark Miller is a retirement columnist and author of The Hard Times Guide to Retirement Security: Practical Strategies for Money, Work, and Living. The views expressed in this article do not necessarily reflect the views of Morningstar.com.

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