By FPA member Jason K. Branning, CFP®
Last Updated: February 27, 2012
Social Security evokes many emotions by Americans – love, hate, ridicule, and praise. The fact remains; Social Security is the most successful social program in history and currently offers guaranteed income which increases over time and continues across your lifetime.1 While successful, it is a nuanced retirement program. One of these complexities is navigating and understanding the tax implications of Social Security’s retirement income.
Not all retirement income streams are equal. Some forms of income are subject to ordinary income tax, others capital gains, and still others, no income tax. It is essential that retirees have a working understanding of this concept, in order to achieve retirement income efficiency. By knowing how Social Security’s income is taxed, retirees can be better empowered to decide when to start collecting monthly retirement income. When it comes to retirement income planning, the net (bring home) income must be planned and managed. (Read Retirement Income Tax Strategies)
Retirement is a consumption phase of life, so maximizing the way retirees use the assets and available income streams is paramount. To maximize all the assets and income streams, a comparison of when retirees take different types of income is beneficial. One major component in deriving a higher net retirement income is through maximizing the tax efficiency of Social Security. Delaying the start of Social Security claiming can prove to be an enormous tax benefit for retirees, as well as serve as a longevity hedge.
Unlike distributions from 401(k)s and traditional Individual Retirement Accounts (IRAs), which are taxed at an individual’s or couple’s ordinary income rates, Social Security offers some tax favorability when income is received. No retiree pays taxes on more than 85 percent of their Social Security benefits, and that percentage can be less.
TABLE A: Income Taxes owed on Social Security Income
|Tax Status||Threshold limit 2011||% Social Security Income Taxed|
|Single||Up to $25,000||0%|
|Between 25,000 and $34,000||50%|
|Married Filing Jointly||Up to $32,000||0%|
|Between 32,000 and $44,000||50%|
Retirees must use the Internal Revenue Service (IRS) “provisional income” formula to determine how much of their Social Security benefits are actually taxable.2 Provisional income is defined by the IRS as the sum of wages, taxable and nontaxable interest, dividends, pensions, self employment and other taxable income plus half (50 percent) of your annual Social Security benefits.3
There are there different calculations that the IRS has set to determine the actual taxable amount of a retirees Social Security benefits. The lowest result of the three thresholds will be added to the total includable gross income. For planning purposes, pre-retirees can compare the tax efficiency of collecting benefits at different ages (use age 62 through age 70 from your Social Security Statement) versus taking some other form of income prior to starting Social Security, like a distribution from a traditional IRA or 401(k), by following the example in Table B below.
Table B, Approach A, evaluates a retired couple who takes Social Security at normal retirement age. In Approach B, the couple waits to collect benefits until age 70. Approach A retirees need $25,000 more annual income (Adjustment Amount) from their IRA than Approach B retirees, who have larger income from Social Security. Even though Approach A and B have the same pre-tax income of $90,000, Approach B proves to be more tax efficient. Approach A’s taxable income is $70,975 while Approach B’s taxable income is $35,350 because of Social Security (a difference of $35,625). If retirees decide to use Social Security as longevity protection for the highest monthly income benefit by waiting to collect until 70, they will also be maximizing income under current law. (See Table B)
In summary, there are many factors that should be considered when you decide to begin Social Security. One of those primary factors is choosing to maximize the tax efficiency of your Social Security Income. For additional information about ways to decide when to take Social Security read Social Security: To Maximize Payments or To Maximize Income? This article does not constitute legal or accounting advice. Please see a qualified professional who can assist you on the basis of your individual facts.
FPA member Jason Branning, CFP®, is a fee-based investment adviser and financial planner with CS Planning Corp. in Ridgeland, Miss. He owns Branning Wealth Management LLC.
Author Note: This article was inspired by the work of James Mahaney & Peter Carlson. “Innovative Strategies to Help Maximize Social Security Benefits”, Prudential Whitepaper, September 2010. Retrieved on 2/15/2012 from http://www.prudential.com/media/managed/IB-InnovativeStrategies.pdf
1 Social Security benefits are subject to Congressional law. Benefits may be reduced or eliminated at any time.
2 http://www.ssa.gov/planners/taxes.htm & IRS Publication 915
3 “Social Security & Taxes.” AARP. October 2011. Retrieved on 2/20/2012 from http://www.aarp.org/content/dam/aarp/work/social_security/2011-10/Social-Security-and-Taxes.pdf