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Facing Up to the Tax on Social Security Benefits
Taxes are a major concern when you are working toward a comfortable retirement. What about when you have finally retired? Believe it or not, you still have to worry about taxes. Case in point: You may have to pay federal income tax on a portion of the Social Security benefits you receive during the year.
How does the tax work? There is actually a "two-tier" approach to taxing Social Security benefits. Here's a brief summary of the rules.
Tier 1: If a taxpayer has provisional income between a base amount of $32,000 and $44,000 ($25,000 and $34,000 for single filers), he or she must pay tax on the lesser of (a) one-half of the benefits or (b) 50% of the amount by which provisional income exceeds $32,000 ($25,000 for single filers).
Tier 2: If a taxpayer has provisional income above $44,000 ($34,000 for single filers), he or she must include in taxable income 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 tier 1 or (b) $6,000 ($4,500 for single filers). In no event, however, can the amount exceed 85% of the benefits received. Note: There are special rules for married taxpayers filing separate returns.
For this purpose, "provisional income" is defined as the taxpayer's adjusted gross income plus tax-exempt income plus one-half of Social Security benefits. In other words, if you receive tax-exempt interest from investments such as municipal bonds, it can increase the tax on Social Security benefits.
Does this sound complicated? It is. Perhaps the best way to understand the full impact of these rules is to look at a hypothetical example.
Facts: The Wilsons, a retired couple, have the same income each year. For simplicity, let's say they receive a taxable pension of $22,000, taxable interest of $10,000, tax-exempt interest of $10,000 and Social Security benefits of $12,000. Based on those amounts, their provisional income is $48,000.
Since the Wilsons have provisional income over $44,000, they are taxed on $9,400 of their Social Security benefits-$6,000 from tier 1 plus $3,400 from tier 2.
In summary: There is a great deal of confusion over these rules. The best approach is to have a professional adviser help you with the computations.