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Attention Retirees: Watch Out for Tax on Social Security Benefits

It's been said that the IRS will get you “coming and going.” A prime example: It was bad enough paying tax on your wages all those years. Now you may have to pay tax on the Social Security benefits received in retirement if your income exceeds a certain threshold.

Background: For 2006, the Social Security “wage base” is $94,200 (up from $90,000 in 2005). In other words, an employee must pay the 6.2% OASDI (Old Age, Survivors and Disability Insurance) portion of Social Security tax on the first $94,200 of wages. The 1.45% HI (Hospital Insurance) Medicare portion of the tax applies to all wages. These figures are doubled for self-employed taxpayers (although half of your self-employment tax is deductible).

When you finally receive Social Security benefits in retirement, you must figure out your “provisional income” to determine your tax liability, if any. Provisional income is defined as your modified adjusted gross income (AGI)—your regular AGI plus certain technical adjustments), plus any tax-exempt income received, plus one-half of the Social Security benefits received. If your provisional income is less than the annual “base amount,” you are in the clear—none of the benefits are subject to income tax. The base amount is $32,000 for joint filers; $25,000 for single filers. (If you are married and choose to file separate returns, the base amount is zero.)

That is the good news. Now the bad news: If your provisional income exceeds the base amount, you must pay income tax on Social Security benefits. The amount of the tax depends on whether you exceed either one or two thresholds.

1. If your provisional income is between $32,000 and $44,000 ($25,000 and $34,000 for single filers), you must pay tax on the lesser of (a) one-half of your Social Security benefits or (b) 50% of the amount by which your provisional income exceeds $32,000 ($25,000 for single filers).

Let's say you are a joint filer, your provisional income is $40,000 and you received $10,000 in annual Social Security benefits. In this case, you must pay tax on $5,000, because half of the benefits received exceed half of the excess over the base amount, or $4,000. If you are in the 25% tax bracket overall, you must pay $1,250 in income tax on your benefits.

2. If your provisional income is more than $44,000 ($34,000 for single filers), the calculation is more complicated. You must pay tax on 85% of the amount by which provisional income exceeds $44,000 ($34,000 for single filers) plus the lesser of (a) the amount determined under the first threshold or (b) a base amount of $6,000 ($4,500 for single filers). In no event, however, can the amount exceed 85% of the benefits received.

Note that investments generating tax-exempt income, such as municipal bonds or municipal bond funds, increase your provisional income. This category may also include interest on U.S. Savings Bonds used to pay college tuition. Thus, there is another inequity in this equation: Income that is supposedly “tax-free” could result in a higher tax bill.

Bottom line: If you are thinking about early retirement, consider all the factors, including the potential tax on Social Security benefits. You might want to postpone retirement for a year or two if you will face a substantial tax bill on your benefits.

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	[ return to list ] Attention Retirees: Watch Out for Tax on Social Security Benefits It's been said that the IRS will get you “coming and going.” A prime example: It was bad enough paying tax on your wages all those years. Now you may have to pay tax on the Social Security benefits received in retirement if your income exceeds a certain threshold. Background: For 2006, the Social Security “wage base” is $94,200 (up from $90,000 in 2005). In other words, an employee must pay the 6.2% OASDI (Old Age, Survivors and Disability Insurance) portion of Social Security tax on the first $94,200 of wages. The 1.45% HI (Hospital Insurance) Medicare portion of the tax applies to all wages. These figures are doubled for self-employed taxpayers (although half of your self-employment tax is deductible). When you finally receive Social Security benefits in retirement, you must figure out your “provisional income” to determine your tax liability, if any. Provisional income is defined as your modified adjusted gross income (AGI)—your regular AGI plus certain technical adjustments), plus any tax-exempt income received, plus one-half of the Social Security benefits received. If your provisional income is less than the annual “base amount,” you are in the clear—none of the benefits are subject to income tax. The base amount is $32,000 for joint filers; $25,000 for single filers. (If you are married and choose to file separate returns, the base amount is zero.) That is the good news. Now the bad news: If your provisional income exceeds the base amount, you must pay income tax on Social Security benefits. The amount of the tax depends on whether you exceed either one or two thresholds. 1. If your provisional income is between $32,000 and $44,000 ($25,000 and $34,000 for single filers), you must pay tax on the lesser of (a) one-half of your Social Security benefits or (b) 50% of the amount by which your provisional income exceeds $32,000 ($25,000 for single filers). Let's say you are a joint filer, your provisional income is $40,000 and you received $10,000 in annual Social Security benefits. In this case, you must pay tax on $5,000, because half of the benefits received exceed half of the excess over the base amount, or $4,000. If you are in the 25% tax bracket overall, you must pay $1,250 in income tax on your benefits. 2. If your provisional income is more than $44,000 ($34,000 for single filers), the calculation is more complicated. You must pay tax on 85% of the amount by which provisional income exceeds $44,000 ($34,000 for single filers) plus the lesser of (a) the amount determined under the first threshold or (b) a base amount of $6,000 ($4,500 for single filers). In no event, however, can the amount exceed 85% of the benefits received. Note that investments generating tax-exempt income, such as municipal bonds or municipal bond funds, increase your provisional income. This category may also include interest on U.S. Savings Bonds used to pay college tuition. Thus, there is another inequity in this equation: Income that is supposedly “tax-free” could result in a higher tax bill. Bottom line: If you are thinking about early retirement, consider all the factors, including the potential tax on Social Security benefits. You might want to postpone retirement for a year or two if you will face a substantial tax bill on your benefits. [ return to list ]
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