Retiree Portfolio Social Security Benefits and Income Taxes

Each year many Social Security benefit recipients are surprised to learn that part of those payments may be considered as taxable income. Worse, they failed to file quarterly estimated income taxes on their Social Security benefits. As a result, they could end up having to pay both the unexpected added income tax plus a penalty.

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By David Braze (TMF Pixy)
November 19, 2001

We are rapidly approaching tax season, so it's a good time for those of us who draw a benefit from Social Security to see how those payments affect our taxes. Step 9 of the 13 Steps to Foolish Retirement Planning addresses that issue by saying:

When and how does Social Security get taxed, you ask? The computation, like all Infernal [sic] Revenue Service requirements, is a tad complicated. In fact, they have a special worksheet just for that purpose. The math starts with your adjusted gross income (AGI). To that you add one-half of all Social Security benefits and all unearned income received during the year. The latter almost always comes from tax-exempt interest received from municipal bonds (a favorite retiree investment). If the computed total is larger than $25,000 (single) or $32,000 (married filing jointly), then up to 50% of the Social Security benefit will be taxed. If the amount is larger than $34,000 (single) or $44,000 (married filing jointly), then up to 85% of the Social Security benefit will be taxed. To determine the exact amount that will be taxed, you must complete the handy-dandy worksheet supplied by the IRS for that purpose. Doesn't that sound like fun?

Fun or not, it is still a drill all those who draw Social Security payments must perform. Let's look at an example of a retired couple, John and Mary, who have the following joint income for 1999:

Pensions and taxable investments    $29,500 
Municipal bond interest               2,000 
Social Security benefit              14,000 

In this scenario, their preliminary AGI consists of their pension and their taxable investment income, or $29,500. To that number, they must add their tax-free municipal bond interest ($2,000) and one-half of their Social Security benefit ($7,000). The resulting sum determines if any of the Social Security benefits will be taxed, and it will give John and Mary their modified adjusted gross income for the Social Security taxation test. If the sum exceeds either the $32,000 or the $44,000 threshold, then part of the Social Security will be taxed. Here's how it works:

Preliminary adjusted gross income   $29,500
Tax-free municipal bond interest      2,000
50% of Social Security benefits       7,000
Modified adjusted gross income      $38,500
Less first threshold amount          32,000
Excess over first threshold          $6,500

John and Mary have exceeded the first test threshold (but not the second), so now they must determine what part of their Social Security benefit will get taxed as ordinary income. That amount is the smaller of one-half of the excess determined above or one-half of the Social Security benefit received during the year. One-half of the excess is $3,250 ($6,500 divided by 2). One-half of the benefit is $7,000 ($14,000 divided by 2). Since, last time we checked, $3,250 is smaller than $7,000, $3,250 is the amount of John and Mary's Social Security benefit that must be declared as taxable income. That brings their reportable AGI to a total of $32,750 ($29,500 plus $3,250).

Didn't I tell you this was fun? But wait! There's more. Let's change things by making John and Mary 70 1/2 years old, the age at which mandatory minimum required withdrawals must begin from traditional IRAs and qualified retirement plans. They hadn't touched these accounts, but now they must. In fact, they had to take $10,000 this year, all of it taxable and all of it part of John and Mary's preliminary AGI. How does that alter the situation? Now their modified AGI and the excess over the two applicable thresholds becomes:

Preliminary adjusted gross income   $39,500
Tax-free municipal bond interest      2,000
50% of Social Security benefits       7,000
Modified adjusted gross income      $48,500
Excess over the first threshold ($48,500 - $32,000):  $16,500
Excess over the second threshold ($48,500 - $44,000): $ 4,500

John and Mary must determine the smaller of:

  • 50% of the excess over the $32,000 threshold, plus 35% of the excess over the $44,000 threshold [($16,500 x 0.5) + ($4,500 x 0.35)]: $ 9,825
  • 85% of the Social Security benefit ($14,000 x 0.85): $11,900
  • 50% of the Social Security benefit plus 85% of the excess over the $44,000 threshold [($14,000 x 0.5) + ($4,500 x 0.85)]: $10,825

The smallest of those three computations, or $9,825, now gets added to John and Mary's preliminary AGI of $39,500 to bring their reportable AGI to $49,325.

In the first case, John and Mary ended up with $3,250 in additional taxable income, and in the second example with $9,825 more. Did they plan for the tax on that income? If not, they could be in for a rude surprise. Not only will they pay more in income taxes, they may also be slapped with a penalty for a failure to pay enough estimated withholding taxes during the year. Estimated income taxes are not withheld from Social Security payments unless the recipient has submitted Form W-4V (Voluntary Withholding Request) to the Social Security Administration (SSA). In the absence of that action, recipients are responsible for those payments. Unless one of the limited safe-harbor tests are passed, failure to make quarterly payments will result in a penalty on top of the taxes due.

Didn't make quarterly payments during the year? Then you may be liable for an underpayment penalty due to insufficient withholdings in the first three quarters of this year when you received those Social Security benefits. But there is a loophole that might allow you to avoid that outcome. If you work part-time, you could ask your employer to withhold additional monies for income taxes for the rest of the year -- up to 100% of your income if need be. Income tax payments withheld from your paycheck don't have to be made quarterly, and they will help offset the amount you may be penalized for a failure to make quarterly payments based on your Social Security checks.

Also, if you determine you must pay more taxes, then don't forget to make your last quarterly estimated tax payment for the year. That's due by Jan. 15, 2002. Pay it on time so you can reduce any potential penalty.

Regardless of your situation this year, consider the potential of Social Security taxation next year. When you do your taxes for this year, run a pro forma tax return for your 2002 income. If you see that your Social Security benefit might get taxed, then either submit Form W-4V to the SSA or make your necessary quarterly estimated withholding payments unless you're absolutely sure you won't owe a penalty for not doing so.

That's it for today. See you next week for my final weekly column for The Motley Fool. As usual, post your comments and queries on our Retirement Investing or Retired Fools boards.

Best to all... Pixy

The Motley Fool may be all about investors writing for investors, but Dave Braze is all about retirement. In 11 days and after he pens one more regular column, he's outta here for his third retirement. Think he'll stay that way this time? With him, you can't tell. But given his peculiar writing style, we can always hope it takes this time.