The taxation of Social Security benefits

Social Security benefits can be partly taxable, under a formula that operates differently from ordinary income and produces some unexpected results.

The formula

Taxability depends on a measure sometimes called provisional or combined income, which is adjusted gross income plus tax-exempt interest plus half the Social Security benefit.

Below a first threshold, none of the benefit is taxable.

Between the first and second thresholds, up to fifty per cent of the benefit becomes taxable.

Above the second threshold, up to eighty-five per cent becomes taxable.

The thresholds differ for single and joint filers, and — the crucial feature — they are not adjusted for inflation.

Why that matters

The thresholds were set decades ago and have never been indexed.

Which means an increasing proportion of recipients cross them each year purely because nominal incomes and benefits have risen.

What was originally designed to affect a small minority of higher-income recipients now affects a substantial share, and the trend continues.

This is worth knowing when planning, because a projection assuming current rules and no indexation implies steadily rising taxation of benefits over a long retirement.

The torpedo effect

The consequence that catches people.

In the income range where the formula is phasing in, each additional dollar of other income makes an additional portion of the benefit taxable.

So a dollar of IRA withdrawal can add more than a dollar to taxable income.

The effect is that the effective marginal tax rate in that range can be substantially higher than the nominal bracket — figures well above the stated rate are commonly cited.

Once the eighty-five per cent maximum is reached, the effect stops and the effective rate returns to the nominal bracket.

Which produces the odd result that the marginal rate can rise and then fall as income increases.

Planning around it

Model actual effective rates. The nominal bracket is not the relevant number in the phase-in range.

Consider whether to accelerate income past the range. Where you will be above the second threshold anyway, taking additional income has a lower marginal cost than partially entering the range.

Use Roth withdrawals to manage it. Roth distributions do not count toward provisional income, which makes them useful for meeting spending needs without triggering additional benefit taxation.

This is one of the stronger arguments for holding Roth assets in retirement.

Convert before claiming. Roth conversions made before benefits begin avoid the interaction entirely.

Note that municipal bond interest counts. Tax-exempt interest is included in provisional income, which surprises people who hold municipal bonds specifically to reduce taxable income.

State treatment

Varies considerably.

A majority of states do not tax Social Security benefits at all. Some tax them following the federal calculation, and some have their own rules and exemptions.

Several states have changed their treatment in recent years, generally in the direction of reducing or eliminating the tax.

Worth checking current rules for your state rather than relying on older information.

Withholding

A practical point.

Federal tax is not withheld from Social Security benefits by default. It can be requested at specified rates using the appropriate form.

Without withholding, tax on benefits and on other retirement income generally has to be handled through estimated payments, and failing to do so can produce underpayment penalties.

Many retirees find it simpler to arrange withholding from Social Security or from IRA distributions than to manage quarterly estimates.

Withholding from an IRA distribution has a useful feature: it is treated as paid evenly across the year regardless of when it occurs, which can correct an underpayment late in the year.

The couple planning point

One implication worth drawing out.

The thresholds for joint filers are not double those for single filers, which means a surviving spouse frequently finds a larger proportion of a smaller benefit becoming taxable.

Combined with the narrower single brackets, this can produce a noticeably higher tax rate on a lower income.

Which reinforces the general argument for recognising income — through conversions in particular — while both spouses are alive and joint thresholds apply.

General information only, not tax advice. Thresholds and state rules change — consult a qualified tax professional about your own situation.