How Social Security Is Taxed (And Why It Changes From Year to Year)

Transcript

Social Security taxation. This is one of those topics that feels heavy for retirees, even though they can't always explain why. What I usually hear is something like, how do we avoid getting our Social Security messed up by taxes? There's this underlying feeling that if you earn too much or do the wrong thing, you somehow break Social Security. And because it's unclear how the rules work, taxes end up driving decisions that were never meant to be tax decisions in the first place.

So let's slow this down and talk about what Social Security taxation actually is, and we'll end by looking at how it shows up on a tax return. Fair warning, this is confusing. It's okay if it doesn't click right away, but there are still some really good takeaways here.

When Social Security starts, it's easy to assume it's taxed like everything else. It isn't. There are separate rules that decide if any of your benefit is taxable and how much gets pulled into your tax return, and that's where the confusion usually begins. Behind the scenes, the IRS runs your Social Security through a separate calculation every year, called provisional income. What the IRS is really trying to understand is simple: how much other income is showing up next to your Social Security. Social Security was designed to be a foundation, and the IRS checks whether it's your main income or income layered on top of other income. When it's layered on top, more of it gets pulled into taxes. Depending on how much other income you have, it determines whether up to 85% of your Social Security benefits are included as taxable income. In other words, either none, some, or most of your annual Social Security shows up on your tax return, based on how much provisional income you have, almost like a measuring stick.

So what is this provisional income calculation? They add together your other income, any tax-free interest like municipal bonds, and half of your Social Security benefit. That total determines how much of your Social Security shows up on your tax return. Your check doesn't change. Your benefit doesn't change. What changes is how much of it shows up on your return. If that provisional income total stays below a certain level, Social Security usually isn't taxed at all. Once you cross the first threshold, up to 50% of your benefit is included as income, and as income continues to rise, up to 85% can be included.

An easy way to picture this is to think of provisional income like a thermostat. Let's look at single filers. If their provisional income is below $25,000, Social Security is generally not taxable. Once you pass $25,000, your benefit starts to gradually get pulled in, and you eventually hit 50% at $34,000. Once you cross $34,000, up to 85% can be exposed. And 85% is the maximum amount of Social Security benefits that can be pulled in as income, so 100% of benefits cannot be taxed.

Another important note: these thresholds were set decades ago and never adjusted for inflation. By today's standards, and you may agree, they're pretty low, which makes Social Security taxation hard to completely avoid. These thresholds don't change, and meanwhile Social Security benefits rise over time, interest income changes, balances grow, and required distributions eventually begin. So more retirees cross into Social Security taxation each year, even if their lifestyle and spending haven't really changed.

Timing and planning matter, because other income that shows up next to Social Security can change how it's taxed. A few income types come into play in retirement, like required minimum distributions, Roth conversions, capital gains, and part-time income. Sometimes it actually makes sense to use some of these strategies even though it means more of your Social Security becomes taxable, while still being mindful not to tip Uncle Sam more than necessary.

Let's quickly look at how this shows up on a tax return. We're going to look into the future and start in 2034. This couple is retired, and we'll focus on two lines, line 6a and line 6b. Line 6a tells us the total Social Security benefits. In 2034, only one spouse is claiming Social Security, for a total of about $30,730. To the right of that, around $26,000 is included for taxes, which is roughly 85%. So essentially we're at the maximum inclusion. Why is it that high? This year, a lot more of their spending need is being taken from the portfolio via portfolio withdrawals. Those withdrawals show up as taxable income, and when that income shows up next to Social Security, the IRS pulls in close to the maximum amount allowed if we're over those thresholds. Nothing is wrong here. This is just how the formula behaves when portfolio income is doing more of the work.

Now let's look at 2035. On line 6a we can see a much larger Social Security benefit. You may guess why: the other spouse is now claiming Social Security. So the total benefits are $70,495, and of that, $34,963 is included for tax purposes, around a 50% inclusion rate. So even though more Social Security is coming in, a smaller percentage is being taxed. Why? Because Social Security is now covering more of their spending needs, which means less money needs to come from the portfolio.

And finally, let's wrap up on 2036, an even larger Social Security benefit. The taxable portion of that total benefit is $27,546, which is around 32%. There are some nuanced rules on why it's 32%, but from a high level, the concept is that by this point Social Security is doing most of the heavy lifting for income. Portfolio withdrawals are lower and more controlled, and with less other income crowding Social Security, the formula pulls in a smaller share.

Yes, Social Security taxation matters, but retirement decisions shouldn't be driven solely by tax consequences, but rather as part of a coordinated income plan. With that approach, Social Security taxation feels more expected and easier to manage. As always, thanks for hanging with me today. I'll see you next time.

Hosted byNick GeorgeCFP®, ChFC®, CLU®, IWA™FounderView bio →

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