Most people are not familiar with the impact of taxation on Social Security benefits. This can be harmful because without proper planning, taxation can reduce Social Security benefits by up to 30% in some cases! This is called the Social Security Tax Torpedo and should be avoided whenever possible.
Whether or not your Social Security is subject to taxation depends on your level of Provisional Income. Provisional income is defined as follows:
Provisional Income = Modified Adjusted Gross Income + Tax Exempt Interest + 50% of Your Social Security Benefits
The provisional Income formula (also known as the Combined Income formula) determines how much of a retiree’s Social Security is subject to taxation. Up to two thresholds, Social Security benefits are tax-free.
Once the first threshold is reached, up to 50% of Social Security benefits are subject to taxation. Once the second threshold is reached, up to 85% of Social Security benefits are subject to taxation. Listed below are the first and second thresholds limits:
Ironically, even though the Social Security Tax Torpedo hits many retirees very hard, few professionals have done much to avoid it.
Social Security income and 401(k)/IRA income are taxed differently which presents opportunities for smart tax planning.
For instance, income received from a Roth IRA is NOT included in the Provisional Income formula which means that if a substantial portion of a retiree’s non-Social Security income comes from a Roth IRA, it is likely that the recipient’s Social Security will be subject to little or no tax.
If you’re only living off of your Social Security income, it will be unlikely that your benefits will be subject to tax, however, if you are not, be sure to plan carefully to structure your income sources to help minimize tax on your Social Security.
Given that a maximum of 85% of your Social Security is subject to tax, that means that at least 15% of your Social Security benefit will be tax-free, it’s possible to minimize this tax burden by working with an advisor that can assist you.
How to Pay Your Social Security Taxes
If you do owe tax on your Social Security benefits, there are a couple of ways that you can pay these taxes:
- You can have them withheld from your Social Security payment each month. When you sign-up for Social Security, you can ask Social Security to withhold taxes from your benefits each month. Or, if you’re already receiving Social Security and want to change your withholding arrangement, fill out the IRS form W-4V to have the Social Security Administration withhold taxes from your monthly benefits.
- The other option is to pay estimated taxes on a quarterly basis. When you file your taxes each year, you can get a refund for any over payment or you can catch-up at that time if you underestimated what should have been withheld.
The Bottom Line
Understanding how your taxes impact your Social Security is an important consideration when deciding when and how to file for your Social Security.
Whether any of the strategies above are right for you requires careful analysis as each situation is different.
Working with a knowledgeable Social Security advisor such as the service offered by SocialSecurityAdvisors.com is highly recommended given the complexity of the rules and that expert advice is critical when determining how best to maximize your Social Security.
Until Next Time,
Matthew Allen is Co-Founder/CEO of Social Security Advisors. As a serial entrepreneur who is driven by a passion for providing industry-leading advice to his clients, Matthew has been at the forefront of financial services for over a decade. Matthew brings insightful product vision, finance, and leadership skills to Social Security Advisors. In addition to co-founding Social Security Advisors, Matthew also founded The Universal Group of Companies, a private investment firm, in 2004. From 2000 to 2004, Matthew was a NYSE Market Maker with LaBranche & Co., a Fortune 500 New York Stock Exchange firm.