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Double Double, Toil and Trouble – Social Security Taxation

Double, double toil and trouble; fire burn and cauldron bubble.” That’s what the witches in Shakespeare’s Macbeth chant. Taxpayers could “get burned” if they earn more than the IRS threshold for Social Security benefit taxation. Exceed a specified amount in wages or other income and you may owe income taxes on part of those social security benefits.

Let’s take a look at the rules and the math.

Who Is Taxed?

As explained by the Social Security Administration, if your “combined income” (defined below) in 2020 is greater than the following amounts, you may be taxed on up to 85 percent of your social security benefits:

  • File as “individual” (single) and your combined income is between $25,000 and $34,000: you may have to pay income tax on up to 50 percent of your benefits. If you earn more than $34,000, up to 85 percent of your social security benefits may be taxable.

  • File a joint return, and you and your spouse have a combined income that is between $32,000 and $44,000: you may have to pay income tax on up to 50 percent of your benefits, If you earn more than $44,000, up to 85 percent of your social security benefits may be taxable.

  • File as married filing separately: you probably will pay taxes on your benefits.

What Income is Taxed?

“Combined income” means your Adjusted Gross Income (AGI) plus tax exempt interest plus ½ of your Social Security benefits. Interestingly, your Traditional IRA distributions are included in your AGI for this calculation, but your Roth IRA distributions are not, making the Roth IRA an even more desirable retirement savings vehicle.

How Can I Pay the Tax?

You can pay taxes when you file your return. Or, you can have the taxes withheld from your benefit check, just as was done when you were working, by filling out a form or calling the IRS. It is usually better and less of a surprise at tax time if you have income tax automatically taken out of your Social Security benefits just like you used to have tax taken out of your paycheck when you worked.

How Can I Avoid or Reduce This Tax?

Since the thresholds that are being used are not adjusted for inflation or changes in average wages, more and more people are likely to need to pay tax on their benefits. Be aware of what income sources will make your benefit taxable. If you continue to work after signing up for Social Security and receive wages or self-employment income, that could push your income up and make your benefit taxable. Interest, dividends, taxable pension payments, traditional 401(k)s, Traditional IRAs, and other taxable income could also lead to part of your Social Security benefit being taxable. Tax-exempt interest income, such as interest earned on municipal bonds or U.S. savings bonds, must also be included in the calculation that determines whether your Social Security benefit will be taxable. Money withdrawn from Roth accounts in retirement, which is typically not a taxable event, will not contribute to making your Social Security benefit taxable. It may be a good strategy to delay claiming Social Security benefits (delaying will give you a higher monthly benefit when you do start taking it) and use pretax 401(k) and IRA balances before signing up for Social Security.

However, keep in mind that it is better to earn money and add to your family coffers rather than pass up needed dollars because you don’t want to be taxed on them! Earning money is great – sure, it is less nice if you earn $1,000 and $200 of it goes to income tax, but the resulting $800 you have in your wallet is much better than having nothing.

How Do I Calculate This Tax?

You tax software or your tax preparer will calculate this for you, but here is the equation used to arrive at combined income.

Adjusted Gross Income (AGI)

+ Nontaxable interest*

+ ½ of Social Security benefits

= Combined Income

*An example of nontaxable interest is municipal bond interest.

Why Must We Pay This Tax?

When the Social Security program started in 1935, benefits were not taxed. In 1983, benefits could be taxed at 50%; in 1993 tax rates went to up to 85%. Could tax rates rise again? It’s hard to say. However, we know that the taxation spell has been permanently cast, and taxation of Social Security benefits is probably here to stay.

Double, double toil and trouble;

Fire burn and caldron bubble.

Cool it with a baboon's blood,

Then the charm is firm and good.

Kathryn Hauer, a Certified Financial Planner ™, adjunct professor at Aiken Technical College, and financial literacy educator wrote the "11-Step, DIY, Comprehensive Financial Plan Workbook" and "Financial Advice for Blue Collar America." Her latest book covers basic concepts of money including insurance and taxes, financial traps to avoid, how to pay for college and tech school, and the bright future ahead for blue collar careers.

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