Why Your Social Security May Be Taxed More Than You Think

For many of those now receiving Social Security after decades in the workforce, it’s eye opening when they realize that Social Security may be taxable upon receipt.

In fact, depending on how much other taxable income you have in retirement, anywhere from zero to 85% of your Social Security income may be taxable. Most articles (as I have done as well) will illustrate this point by showing the following information:

For an individual, the key numbers are as follows (for 2015):

  • If your “combined income” is less than $25,000, then you will not be taxed on your Social Security income.
  • If your “combined income” is between $25,000 and $34,000, then you may be taxed on up to 50% of your Social Security benefit.
  • If your “combined income” is above $34,000, then you may be taxed on up to 85% of your Social Security benefit.

For “Married Filing Jointly,” the key numbers are as follows:

  • If your “combined income” is less than $32,000, then you will not be taxed on your Social Security.
  • If your “combined income” is between $32,000 and $44,000, then you may be taxed on up to 50% of your Social Security benefit.
  • If your “combined income” is above $44,000, then you may be taxed on up to 85% of your Social Security benefit.

While this is all true and accurate information, it is not very helpful without also doing a full analysis of the impact of IRA distributions and the opportunity to plan for the taxation of Social Security.

It’s additionally incomplete in illustrating that while additional IRA distributions may fill up a 10 or 15% tax bracket, the average tax cost of these dollars may be considerably higher.

Let’s explore how this works.

The Hypothetical Example

For purposes of illustration, I’m including a hypothetical example. However, this is simply one example, and any changes to the numbers may impact the outcome. That is why it’s important that you evaluate how the concepts discussed below will impact your personal plan.

For our purposes, we assumed the following hypothetical couple:

  • Married couple, age 66
  • Combined Social Security income: $45,000
  • Standard deduction
  • Two exemptions

Using this hypothetical example, we can begin to illustrate the impact that IRA distributions may have on the taxability of Social Security.

The Zero Tax Bracket

Income received from Social Security is not always taxable. In fact, depending on how much taxable income you have and where that taxable income is sourced from, it is possible to receive Social Security and pay nothing in income tax as a result.

However, if you find yourself collecting Social Security and paying nothing in tax, you may be leaving something on the table. “Something,” in this case, may be the ability to withdraw more IRA dollars while continuing to pay zero tax.

Therefore, one goal may be to consider the maximum amount of ordinary income that may be claimed prior to owing income tax, in essence “filling up” the zero percent tax bracket. To put this another way, how much money can you withdraw from an IRA while collecting Social Security and still pay no tax?

If done correctly, one can argue that this is the maximum benefit possible. A tax deduction upon contribution to the IRA, tax deferred growth for potentially many years, and tax-free income upon receipt all contribute to a zero tax bracket.

Using the same example as above, we can calculate the maximum withdrawal from an IRA to be $18,636. Assuming a withdrawal of $18,636, there will be zero income tax owed.

IRA Distribution $18,636 $18,637
Taxable Social Security $4,568 $4,569
Total Taxable Income $23,204 $23,206
Deduction $15,100 $15,100
Exemption $8,100 $8,100
Taxable Income $4 $6
Tax Owed $0 $1

 

In this example, one can withdraw $18,636 from an IRA without paying any tax.

Interestingly, you will notice that if the retiree is to withdraw $18,637, $1 will be owed in tax (basically a 100% tax bracket). Additionally, that $1 IRA withdrawal will make an extra dollar of Social Security taxable as well.

The 10% Tax Bracket

While withdrawing from an IRA and paying nothing in tax is the best option, it’s possible (even likely) that you may need to withdraw more from your IRA to support your lifestyle. Due to the need to support a certain lifestyle, it makes sense that many retirees pay more than zero percent and are instead forced into a 10% tax bracket.

As you begin to creep into the 10% tax bracket, it makes sense to ask a similar question as above. How much money can I withdraw until I max out in the 10% tax bracket?

Following the same logic as above, we can calculate a maximum IRA withdrawal to be $29,202.

IRA Distribution $29,202 29,203
Taxable Social Security $12,547 $12,548
Total Income $41,749 $41,751
Deduction $15,100 $15,100
Exemption $8,100 $8,100
Taxable Income $18,549 $18,551
Tax Owed $1,853 $1,859

 

It’s interesting to notice a few things regarding this analysis. Most notably, you will notice that on an IRA withdrawal of $29,202, $1,853 in taxes are now owed.

Why is this interesting, you ask?

It’s interesting to see that by “filling up” the 10% tax bracket, the average tax bracket on the additional withdrawal is actually 17.54%.

Let’s look at this more closely.

If we compare the two examples above, we see that in the zero tax bracket scenario, we had an IRA withdrawal of $18,636. In the 10% tax bracket example, the IRA withdrawal was $29,202. The only difference between the two scenarios is the IRA distribution, with the difference being $10,566.

We can further assume that the additional taxes owed due to the increased IRA distribution will be $1,853.

Therefore, the average tax rate on this withdrawal (while filling up the 10% tax bracket) is actually 17.54%.

One reason for this substantially higher tax rate is the impact the additional IRA withdrawal has on the amount of Social Security income that is taxable upon receipt. In short, a higher IRA withdrawal makes more Social Security subject to tax than in the earlier example. As you can see from the charts above, the amount of taxable Social Security increased to $12,547 from $4,568.

From a practical standpoint, this illustrates the point that distributions from an IRA combined with receiving Social Security may actually increase the taxes owed substantially more than what you think they will.

The 15% Tax Bracket

If we continue the example into the 15% tax bracket, we can further illustrate the point that increased IRA distributions coupled with Social Security income may create an average tax on IRA distributions that is higher than what is one would think.

In this example, we can calculate the maximum IRA distribution to “fill up” the 15% tax bracket to be $60,249.

IRA Distribution $60,249 $60,250
Taxable Social Security $38,250 $38,250
Total Income $98,499 $98,500
Deduction $15,100 $15,100
Exemption $8,100 $8,100
Taxable Income $75,299 $75,300
Tax Owed $10,374 $10,374

 

Following similar logic as above, we can figure an IRA distribution of $31,047 caused an additional tax liability of $8,521, or 27.45%. So while we are “filling up” the 15% tax bracket, the actual average tax cost ends up being considerably higher.

Again, a major culprit of this additional tax is the impact that additional IRA distributions have on the taxability of Social Security income. By filling up the 10% tax bracket, the total amount of Social Security income that is taxable is $12,547. When filling up the 15% tax bracket, the total amount of Social Security that is taxable is now $38,250.

It is interesting to note that by filling up the 15% tax bracket, we also max out on how much Social Security income is taxable. In this example, $38,250 is 85% of the total Social Security received ($45,000).

Planning Opportunities

By understanding how Social Security is taxed as well as how other income sources impact the taxability of Social Security, one can begin to plan for income in retirement.

For example, it may be possible to keep income low enough in one year so that no Social Security will be taxed.

It also may be possible to withdraw more from an IRA now as opposed to later. By doing so, you may be able to fill up lower tax brackets, subsequently paying a lower tax rate now rather than later.

Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts. Please consult with your tax advisor for more information concerning your individual situation.

Taxes must be paid in the year of withdrawal for any deducted contributions plus earnings and on the earnings from your non-deducted contributions to an IRA.

The above figures are for illustrative purposes only and do not attempt to predict actual results of any particular investment.

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