Editor's Note: This article was originally published in the October 2012 issue of Kiplinger's Retirement Report.
It's time to retire, and you're counting on your Social Security check to cover certain expenses. Curb your enthusiasm: You may need to hand part of your benefit back to Uncle Sam.
About 25 million Americans pay income taxes on their Social Security benefits -- a surprise for many seniors who were planning on a source of tax-free income. Depending on your income, you could pay tax on up to 50% or up to 85% of your benefits.
As you prepare for retirement, it's essential to determine if your benefits will be tax free or vulnerable to a tax hit. The first step is to compute your "provisional income," which is basically your adjusted gross income (not counting any Social Security benefits) plus any tax-exempt interest and 50% of your benefits.
Your benefits are totally tax free if your provisional income is less than $25,000 and you file a single or head-of-household tax return. That threshold rises to $32,000 if you file a joint return.
No more than half of your benefits can be taxed if your provisional income is between $25,000 and $34,000 on a single return or between $32,000 and $44,000 on a joint return. The amount included in taxable income is either half of your benefits or half of the amount by which provisional income exceeds the trigger point -- whichever is less.
Say you and your spouse file a joint return. Your AGI for the year is $30,000, and you have $4,000 of tax-free interest income from municipal bonds and $5,000 of benefits. Adding your AGI ($30,000), your tax-exempt interest ($4,000) and half of your benefits ($2,500) gives you a provisional income of $36,500. That's $4,500 over the $32,000 threshold for joint returns. Since half of that amount ($2,250) is less than half your benefits ($2,500), the smaller amount becomes taxable income. In the 15% bracket, the $2,250 will cost $337.50 in extra federal income tax.
A Bigger Tax Bite on Higher Incomes
When provisional income exceeds $34,000 on a single return or $44,000 on a joint return, 85% of your benefits will be taxed in almost all cases. You can use an 18-line IRS worksheet to figure how much of your benefits will be taxable. You can find the worksheet online at www.irs.gov. The threshold is $0 for married couples who file separate returns, and these couples can be certain that 85% of their benefits are taxable.
Consider how the tax hits the higher-income beneficiary. Let's say your AGI is $80,000 and you and your spouse receive a total of $25,000 in benefits. The maximum 85% ($21,250) would be taxed, costing you $5,312.50 in extra federal income tax in the 25% bracket. Most states that have an income tax don't touch Social Security benefits.
You can limit the bite with some tax planning. Working around your annual required minimum distributions, you may be able to stagger other IRA withdrawals so that your benefits are taxed only in alternate years. Tax-free withdrawals from a Roth IRA can push more of your Social Security benefits into the tax-free range. Timing the sale of stocks or other appreciated property also can pay off: By taking profits in years when 85% of your benefits will be taxed anyway, you can limit gains in intervening years to reduce the amount of your benefits that will be taxed.
These strategies can be more important than they appear. Say you're single and your provisional income is between $25,000 and $34,000. In that range, adding $100 of extra income lets the IRS tax $150 -- the $100 plus $50 of otherwise tax-free benefits. In the 15% bracket, that costs you $22.50 -- boosting your effective tax rate to 22.5%. If your provisional income is higher, an extra $100 can make $85 of benefits taxable. Taxing $185 at 25% costs you $46.25 -- an effective rate of 46.25%. Squeezing provisional income by $100 can produce savings at the same higher rates.
If you so desire, Social Security will withhold income tax from your benefits. That withholding lets you avoid making quarterly estimated payments of the tax due on your benefits or other taxable income. To request withholding, file a W4-V form with the Social Security Administration.