Will I Owe Income Tax on My Social Security Retirement Benefits?

For the remainder of 2020, the financial seminars I present at local libraries are now virtual. Although I miss the interaction with a live audience, this unique opportunity has allowed people who would not otherwise be able to attend the chance to participate. If you are at or near retirement age, then I would like to invite you to attend one of these free social security webinars. A full listing of upcoming webinars and the registration links can be found on my website. https://thedalagroup.com/events/

One of the most commons questions received during the presentation is whether social security benefits are taxable. This month’s article will help you determine if you will owe taxes on your social security benefits and then provide you with planning strategies to minimize any taxes due.

How do I determine if federal income tax is due on my social security benefits?

The IRS provides a worksheet to determine if social security benefits are taxable. As with any IRS form, the process can be tedious so below is a simplified process to determine the taxes due.

1. Determine the amount of social security benefits paid for the previous year. This information can be found in box 5 on form SSA-1099 provided by the social security administration.

2. Calculate adjusted gross income for the previous year by combining all the following:

   1. Wages

   2. Salaries

   3. Tips

   4. Interest earned including municipal bond interest

   5. Ordinary dividends

   6. Capital gains

   7. IRA distributions

   8. Pension income

   9. Annuity income

   10. Other income listed on IRS Form 1040 Schedule 1, Line 9 such as alimony received, business income, rental real estate income, unemployment compensation

3. Calculate Provisional Income

4. Calculate the amount of the social security benefit which is treated as federal taxable income by comparing provisional income to the following chart:

Below are two examples to clarify:

Example 1
Tom and Emily are married and collecting $30,000 per year in social security retirement benefits. They file jointly on their tax return. In addition to their social security benefits, they have $50,000 of taxable income including IRA withdrawals and Tom’s pension. Based on the provisional income equation in step 3, their provisional income is $65,000 for the year. When we compare that to the table in step 4, they are over the $44,000 limit in the last column. Therefore, up to 85% of their social security income will be treated as taxable income. If we take their $30,000 in social security benefits and multiply by 0.85, we are left with $25,500. This is the amount that will be added as taxable income on their federal tax return and the amount of tax due will depend on their federal tax bracket. In this example, their federal tax bracket is 12% so they will owe $3,060 in taxes on their social security benefits.

Example 2
Roger and Jane are married and collecting $30,000 per year in social security retirement benefits. They file jointly on their tax return. In addition to their social security benefits, they have $16,000 of taxable income including IRA withdrawals and CD interest. Based on the provisional income equation in step 3, their provisional income is $31,000 for the year. When we compare that to the table in step 4, they are under the $32,000 limit in the first column. Therefore, none of their social security income will be treated as taxable income and no federal tax will be owed.

How do I determine if I will owe state income tax on my social security benefits?

Many states do not impose income tax on social security benefits including Illinois. There are currently 13 states that do tax social security benefits. Each of the 13 states tax social security differently so it is best to check with a tax preparer. Here is a list of the 13 states in alphabetical order:

1. Colorado

2. Connecticut

3. Kansas

4. Minnesota

5. Missouri

6. Montana

7. Nebraska

8. New Mexico

9. North Dakota

10. Rhode Island

11. Utah

12. Vermont

13. West Virginia

What planning opportunities are available if our provisional income exceeds the $34,000 limit as a single individual or the $44,000 limit when married?

When trying to minimize federal taxes owed on social security benefits, the focus is on reducing taxable income for the year. When the taxable income is coming from sources such as pensions, annuities or required minimum distributions which cannot be eliminated, little can be done. In other cases where the taxable income is from traditional IRA withdrawals or capital gains, there are potential planning opportunities available. Here are two planning opportunities that come to mind:

1. Eliminate IRA withdrawals and transactions which will result in realized capital gains for the year and use money in savings, money markets, or CD’s for living expenses. This will reduce the taxable income that is reported and therefore also reduce the provisional income.

2. Withdrawal money from a Roth IRA instead of a traditional IRA to reduce taxable income. Here is an example of two couples that require the same amount of annual income but are taxed very differently on their social security benefits.

Notice that couple 1 is withdrawing $25,000 from a traditional IRA whereas couple 2 is withdrawing $25,000 from a Roth IRA. Without making any other changes to income, couple 2 can avoid paying federal taxes on their social security benefits.Where can I get more information on social security benefits?

“What to Look For on Your Social Security Benefit Statement” and “Social Security Spousal and Restricted Spousal Benefits” are articles from previous months and excellent resources. Additionally, the social security administration (www.ssa.gov) has valuable information on their website.