Social Security Benefits and Tax Planning

This is the 2nd part of “All You Need to Know about Social Security Benefits”. The article focuses on the tax impact and tax planning for Social Security Benefits.

In previous post part 1, I’ve talked about when a person collects Social Security earlier than his/her full retirement age which is from 65 to 67, depending on the year of birth, he/she will get a reduction in benefits up 30%. In addition, if the person who is younger than full retirement age works while collecting the benefits, $1 in benefits will be withheld for every $2 or $3 he/she earns above the maximum earnings limit.

Care should be taken to avoid unnecessarily increasing the amount of Social Security benefits subject to tax

Tax Computation for Social Security Benefits

If social security benefit is only the source of income, most likely the taxpayer doesn’t have to pay income tax on any portion of social security benefits. In addition, the taxpayer may not even have to file the tax return in this situation.

However, if the taxpayer has other income, he/she may be required to file the tax return. Moreover, depending on income level, the maximum of 85% of social security benefits to be included in the adjusted gross income for tax purpose.

Single, HOH, QW, MFS* (and lived apart from spouse the entire year)
Base Income	% of Benefit which is taxable income
< $25,000	0%

Head of Household (HOH), Qualified Widower (QW), Married Filing Separate (MFS)

Computation

The taxable portion of Social Security benefits is taxed as ordinary income on Form 1040. In general, depending on the income levels, a tax payer’s social security benefit can be 0%, 50% or 85% taxable income depending on the provisional income. I just want to clarify that it’s not 50% or 85% tax on the social security benefits but 50% or 85% of the benefit will be added to total taxable income for income tax. It means that the taxable portion of the social security benefits will never exceed 85% of the total benefits. The math formula to determine how much of the social security benefits will be added into adjusted gross income for tax purpose is rather complicated; so I won’t show the calculation in this post.

Provisional Income

Provisional Income is calculated to determine the percent of social security benefit to be taxable

• 1/2 of social security benefits (Box 5 from SSA-1099 and RRB-1099 form) (1)

• Total taxable income (excluding social security benefits), such as pensions, wages, interest, ordinary dividends, and capital gain distributions. Do not reduce income by any deductions, exclusions, or exemptions (2)

• Tax-exempt interest income such as interest on municipal bonds (3)

Provisional income = (1) + (2) + (3)

The provisional income is now to compare with the base income in the above table to determine the percent of the benefit to be taxable income. So now, let’s go through few examples to understand the computation.

Example 1

Michael who is 65 years old files tax using Single filing status with standard deduction. His income includes taxable 401k distribution of $14,000 and social security benefits of $20,000. Michael’s provisional income for 2020 is calculated as below:

401k distribution: = $14,000

1/2 of social security benefit: $20,000/2 = $10,000

Provisional income = $14,000 + $10,000 = $24,000 which is lower than the base income of $25,000 for single filing status. So, all of his $20,000 social security benefit is not taxable

Because Michel’s social security benefit is not taxable, Michael’s income includes only 401k distribution of $14,000. Therefore, the taxable income after standard deduction is $1,600 ($14,000 – $12,400). Federal tax is $161 and if Michael is California resident, there’s also $0 CA tax with this income.

Example 2

Same example 1 except that Michael decided to distribute another $20,000 from 401k to purchase a new car. The provisional income now is calculated as:

401k distribution ($14,000 + $20,000) = $34,000

1/2 of social security benefit: $20,000/2 = $10,000

Provisional income = $34,000 + $10,000 = $44,000 which is higher than the base income of $25,000 for single filing status. So, $13,000 (the calculation is not shown here) of social security benefit will be taxable

• Income Tax Calculation
  • 401k distribution ($14,000 + $20,000) = $34,000
  • Taxable Social Security benefit = $13,000
  • Adjusted Gross Income (AGI) = ($29,000 + $8,750) = $47,000
  • Standard Deduction = ($12,400)
  • Taxable Income ($37,750 – $12,400) = $34,600
  • Tax = $3,958
  • CA tax = $539

Compared to example 1, $20,000 increase in income results in an addition of $4,336 in tax ($3,958 federal tax + $539 CA tax – $161 federal tax from the example 1)

Example 3

Same as the example 2; however, if Michael takes out a car loan of $20,000 rather than take an additional $20,000 of 401k distribution, his provision income won’t change from the example 1. Therefore, none of his $20,000 social security benefit is taxable. Michael’s federal tax is still $161 and $0 CA tax.

State Taxes impact

In addition to federal taxes, some states levy on Social Security benefits. State tax is also important as it impacts the take home benefits. Depending on the states where a taxpayer lives, some states don’t collect income tax or don’t consider social security income into tax consideration. However, some states comply with federal which taxes up to 85% of benefits while others tax on social security benefits and having some tax breaks based on ages and income level.

At the time of this article, most states don’t tax social security benefits. However, these below states tax on social security benefits. Please check with local tax professionals for state tax planning.

Colorado, Connecticut, Kansas, Minnesota, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont, West Virginia.

Tax Planning for Social Security Benefits

In order to minimize the taxable amount, care should be taken to avoid unnecessarily increasing the amount of Social Security benefits subject to tax. Few recommendation for different types of investment to reduce tax and improve the bottom line.

Dividend paying stocks.

Dividend paying stocks usually pay qualified dividends which have a maximum of 20% tax rate rather than at ordinary tax rates (maximum of 39%). The income from dividends won’t change the taxable portion of the social security benefits but it will bring lower tax on the same amount of total income.

Investments that produce capital gains.

Invest into real estate or stock/mutual funds which produce capital gains. If the taxpayer does not need current income, he or she may realize current year tax savings and defer taxes until the assets are sold. In addition, when the taxpayer sells the asset, he or she will pay taxes at the capital gains tax rate (maximum of 20% for long term capital gain for assets being hold for more than 1 year) versus the ordinary income tax rate (a maximum of 39%). By investing in assets that produce capital gains, taxpayers can lower the overall tax and control when to sell assets to optimize tax savings.

Non-qualified annuities

Non-qualified annuities are backed by the assets of the insurance company. Many states regulate insurance companies that offer annuity contracts which guarantee principal; states also require insurance companies to maintain certain funding levels to help prevent them from defaulting on the investment. So non-qualified annuities can guarantee principal and reduce overall taxes until the investment is distributed.

References

• Retirement Benefits
  • https://www.ssa.gov/benefits/retirement/