Many retirees are surprised when they lose a substantial chunk of their Social Security income to taxes. Here is what you need to know: if your gross income amounts to less than $25,000 a year (excluding one-half of your Social Security benefits), none of your monthly check will be taxed. Or, if you are married and you and your spouse together make less than $32,000, you are also in the clear. However, as soon as you enter the next income brackets – which I am sure include many of you – the rules change dramatically.
Social Security Tax Rate
Married couples that make between $32,000 and $44,000, for example, will have to pay taxes on up to 50% of their Social Security. Furthermore, couples making over $44,000 will probably pay taxes on as much as 85% of their benefits. This does not mean the federal government will take away 50% or 85% of your Social Security. The percentage only indicates the portion of your benefits that will be subject to taxation. And under federal law, the government can never tax more than 85% of your Social Security income – regardless of how much money you make.
One interesting wrinkle that can trip you up when calculating the income thresholds above is that nontaxable interest actually counts towards the total. For example, if you and your spouse have $42,000 in taxable income plus $3,000 in interest from tax-free municipal bonds, you would probably assume that only 50% of your Social Security benefit is subject to tax. However, you would be wrong! The federal government counts the tax-free interest, so your combined income would be $45,000 for purposes of calculating the Social Security benefits tax. Instead of 50%, you would have to pay tax on 85% of your Social Security. This policy has the effect of turning what should be tax-free income into taxable income.
Annuities & Social Security Taxes
Annuities can help to alleviate this problem, since no taxes are paid on deferred annuities until a withdrawal is made and payments from annuities include a return of principal that is not counted as income. So many seniors are not aware that their tax-free bond interest counts towards the taxation of their Social Security benefits. When I was a financial advisor, I was able to help many seniors reduce or completely eliminate the taxation on their Social Security benefits – simply by moving tax-free bonds or CDs just sitting in the bank into deferred or income annuities. If you have a large pension or other income from an asset that cannot be moved into an annuity, you will likely be paying taxes on 85% of your Social Security benefits.
Once you retire and begin taking Social Security, you will receive a Social Security Benefit Statement in the mail each January for the rest of your life. If you have questions about whether you owe taxes on your Social Security, this form should be able to answer them. If it turns out that you do have to pay taxes, you have two options. Your first option is to make quarterly tax payments to the IRS each year based on your adjusted gross income. But the second option is simpler. Instead of receiving the money and then having to pay it right back to the government, you can simply opt to have the tax money withheld from your monthly Social Security checks, much like when you were working. This way, it will at least seem like that lost money never existed in the first place.
