First, the good news:
Even though up to 85% of social security benefits can be taxed, most beneficiaries still get all of their benefits tax-free.
The bad news is that Congress seems determined to make this issue more and more complicated.
Not so long ago, the tax rules for Social Security benefits were the epitome of simplicity: Benefits were tax-free. Period.
Now beneficiaries fall into one of three tax categories:
If you're among the 10 million or so retirees whose benefits are taxed, the formula for figuring how much the IRS gets effectively imposes a back-door tax on income from otherwise tax-free bonds.
Your benefits are vulnerable if your "provisional income" exceeds a particular amount based on your filing status. Provisional income is your adjusted gross income plus tax-exempt interest plus 50% of your Social Security benefits. The thresholds are $32,000 on a joint return, $25,000 if you file a single or head of household return or married and file a separate return and did not live with spouse during the year and $0 if you are married and file a separate return and lived with spouse during the year. (Unlike many other thresholds in the tax law, these figures are not indexed to rise with inflation.)
If your provisional income is below the threshold for your filing status, your benefits are tax free. If your income exceeds the threshold, part of your benefits are taxable. If your provisional income exceeds the $25,000/$32,000 level, up to 50% of your benefits can be taxed, as shown in this example:
Assume you and your spouse file a joint return. Your AGI for the year is $30,000, and you have an extra $4,000 of tax-free interest from municipal bonds and $5,000 of Social Security benefits. Adding your AGI ($30,000), your tax-exempt interest ($4,000) and half of your benefits ($2,500) gives you $36,500. That's $4,500 over the $32,000 threshold for joint returns. Since half of that amount ($2,250) is less than half your benefits ($2,500), the smaller amount is the part of your Social Security that is taxed. In the 28% bracket, the extra $2,250 of taxable income will cost $630.
Now, for the higher thresholds—$34,000 on single returns and $44,000 on joint returns — that allow the IRS to tax up to 85% of some taxpayers' benefits.
There's a lot of confusion here. Anyone who thinks benefits are tax free up to the higher thresholds is sadly mistaken.
As things stand now, to know how much of your benefits are taxable, you begin by figuring your provisional income. It's figured as: Adjusted gross income, plus tax-free income, plus 50% – not 85% –of Social Security benefits.
If the total is below the $25,000/$32,000 thresholds, your benefits remain tax free.
If the total is between the $25,000/$32,000 thresholds and the $34,000/$44,000 levels, either 50% of the amount over the thresholds, or 50% of your benefits – whichever is less – is taxable.
When provisional income exceeds the $34,000/$44,000 thresholds, though, an even more complicated formula comes into play that, in most cases, will tax 85% of your benefits. Fortunately, TaxCut will handle all the mathematical gymnastics for you.
If your benefits are threatened, some planning can help limit the bite. If your AGI will include amounts withdrawn from an IRA, for example, you may be able to stagger your withdrawals and vary your income so that your Social Security benefits are taxed only in alternate years. The same goes for the sale of stocks or other appreciated property. By timing your sales, you may be able to boost your income in years when 85% of your benefits will be taxed anyway and limit income in intervening years to reduce the amount of your benefits that fall prey to the IRS.
If you have municipal bonds, you may consider unloading them now that this "tax-free" income can trigger a tax on your Social Security benefits. That could backfire, however, because switching to a comparable taxable investment would probably give you a higher yield that could push even more of your benefits into the taxable range. Even though tax-exempt income is taken into account in the Social Security formula, the income itself is still not taxed.