Taxation of Social Security benefits has been a thorn in Congress’ side ever since it came into being in 1984. As aptly stated by one of Retirement Income Visions’™ readers after reading Part 1, it’s a tax on a tax. After having one’s earnings, up to a maximum limit, reduced by a payroll tax of 6.2% for all of one’s working life, it’s difficult for Social Security recipients to stomach the fact that their benefits may be reduced by yet another tax — income tax.
Per last week’s post, since 1984, up to 50% of Social Security benefits became subject to income tax, with this percentage increasing to 85% beginning in 1994. Although the “combined income” (50% of Social Security benefits plus adjusted gross income increased by tax-exempt income) thresholds are relatively low for having up to 85% of one’s benefits subject to tax (i.e., greater than $34,000 if you use single, head of household, or married filing separate filing status and over $44,000 for married filing joint status), and, furthermore, haven’t ever been increased for inflation, you will never forfeit 85% of your benefits.
As explained last week, the maximum percentage of your Social Security benefits that you will lose to federal income tax is 29.75%. Furthermore, this will only occur if your “combined income” is several hundred thousand dollars. Even if up to 85% of your Social Security benefits are subject to taxation, it’s possible that you may only lose 5% of your benefits to income tax if your combined income is low.
To demonstrate this and to help you better understand the taxation of Social Security benefits, I have prepared Exhibit 1. This exhibit includes nine different scenarios for nine hypothetical people who receive Social Security income of $20,000, other income ranging from $15,000 to $270,000 depending upon the scenario, uses single filing status, and claims one exemption and the standard deduction.
“Combined income” is calculated in each scenario, which is equal to 50% of Social Security benefits, or $10,000 (50% x $20,000), plus adjusted gross income increased by tax-exempt income. Since single filing status is being used, the maximum taxable Social Security benefits percentage will be as follows:
Maximum Taxable Percentage
|Less Than $25,000|
|$25,000 – $34,000|
It’s important to note that the maximum taxable percentages per the above table are exactly that – maximum percentages. As examples of this:
- Even though the maximum taxable Social Security benefits percentage is 50% in scenario #2, only $3,000, or 15% ($3,000 divided by $20,000), is taxable.
- Even though combined income exceeds $34,000 beginning with Scenario #3, it isn’t until Scenario #5 when combined income is equal to $48,706, that 85% of Social Security benefits of $20,000, or $17,000, is taxable.
After calculating the amount of combined income and taxable Social Security benefits, each scenario shows the amount of federal income tax including and excluding the taxable Social Security benefits. The difference between these two amounts is the tax that is attributable to the taxable Social Security benefits. The amount of tax that is attributable to the taxable Social Security benefits is then subtracted from the Social Security benefits of $20,000 to arrive at “Social Security Benefits Net of Federal Income Tax,” or net Social Security benefits. This is the amount of Social Security that the hypothetical person in each scenario gets to keep after paying the income tax that is attributable to the taxable portion of his/her benefits.
As a final step, the “Social Security Benefits Net of Federal Income Tax” is divided by the Social Security benefits of $20,000 in each scenario to determine the percentage of Social Security benefits that is retained after paying the tax that is attributable to the taxable portion of benefits. Based on the maximum taxable Social Security benefits percentage, the percentage of benefits retained is greater than what one might envision before running the calculations. As examples of this:
- 97.8% of benefits are retained in scenario #2 even though the maximum taxable Social Security benefits percentage is 50%.
- 94.7% and 90.3% of benefits is retained in scenario #3 and #4, respectively, even though the maximum taxable Social Security benefits percentage is 85%.
- Approximately 75% to 80% of benefits are retained in scenarios #5 through #8 even though the maximum taxable Social Security benefits percentage is 85%.
It isn’t until we get to scenario #9 where we get close to the maximum percentage of Social Security benefits that you can lose to income tax, i.e., 29.75%. It is in this scenario with combined income of $280,000 that 28% of Social Security benefits are lost to federal income tax and 72% is retained.
While it seems unfair to most Social Security recipients that their retirement benefits are subject to taxation, hopefully it’s somewhat comforting to know that the percentage of benefits lost to income taxation in most cases isn’t as high as one might have thought before reading this post.