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How Are Social Security Benefits Taxed?

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Understanding how your Social Security benefits will be taxed is critical for developing an accurate view of your retirement plan.

Determining how much of your Social Security will be taxed is easy. You can use our tax calculator to enter your Social Security benefits then, after entering your other income, the calculator will show how much of your benefit will be taxed. The formula the IRS is using to come up with the amount taxed is, however, complicated. Knowing how this formula works can lead you to a better decision on when it is most advantageous for you to take your benefit from a tax perspective.

The first step in the formula is to calculate provisional income. Provisional income equals your adjusted gross income (all taxable income from sources other than Social Security) plus one half of your Social Security plus tax exempt interest. The amount of provisional income determines the amount of your benefit that can be taxed, as shown in the chart below:

The third column states “up to” for all the limits. These are not cliff limits. Once the first limit is crossed, more and more of your benefit will be taxed as provisional income increases.

Going back to the formula for provisional income you should notice a couple of things. The first thing that should be apparent is that you may lose the benefit of tax exempt bonds. While the interest from these bonds continues to be tax free, this interest can cause more of your Social Security to be taxed, negating the advantage.

The second thing to notice in the formula is that only one half of your Social Security benefit is being added to provisional income. This means that the higher your Social Security to other income ratio is, the lower provisional income will be. 

For instance, let’s assume a couple has combined Social Security benefits of $48,000 if they take their benefits at age 66. Let’s further assume that they would need $6,000 per month, net after tax to live on. To get to this amount they would have to take $25,000 out of their IRAs to get their $6,000 per month. $10,250 of their Social Security benefit would be added to their taxable income (21.35% of their benefit is taxable) and they would owe $995 in federal taxes.

If they delay their Social Security the benefit goes up 8% per year for every year delayed. If they had other sources of cash flow from savings, etc. and delayed their Social Security until age 68, their combined benefits would be $55,680. To get to their cash flow goal of $6,000 they would only need to pull $16,320 from their IRA’s and no taxes would be due. This happens because with the ratio of Social Security to other income being higher only $6,136 of the benefits are taxable. Adding this amount to the IRA distribution is less than the current standard deduction for a couple over 65 so no taxes are due.

While it may seem that it should always make sense to delay your Social Security because a higher benefit will result in lower taxes this is not necessarily the case. Other factors that play into the analysis are total IRA balances, income from other sources such as rental properties, pension income and earnings from taxable investment accounts. And, just to complicate things further, the tax code we are operating under today is due to sunset in five years.

I would be happy to combine all your projected income sources together to develop a comprehensive tax projection. Knowing what your taxes look like in the future typically leads to better decision making today.

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