If you follow Social Security, then by now you've probably heard about the big cost-of-living adjustment (COLA) that could boost Social Security benefits by 8% or 9% in 2023. This would be the largest COLA increase retirees have seen in decades. While the boost will be welcome, retirees should be aware of its implications, such as the potential to increase the taxes you pay on your benefits. Here's why the big upcoming COLA increase also could become a tax headache if you're not careful.
How Social Security benefits are taxed
The somewhat good news is that no retiree will ever have to pay taxes on all of their Social Security benefits. The bad news is that you still may have to pay taxes on half of your benefits and could possibly have to pay taxes on as much as 85% of your benefits.
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What you pay taxes on will depend on your combined income, which the Social Security Administration defines as:
- Adjusted gross income such as wages, dividends, certain retirement income, etc.
- Nontaxable interest such as income from municipal bonds.
- One-half of your Social Security benefits.
If your combined income is between $25,000 and $34,000 as an individual, you likely will need to pay income taxes on as much as half of your Social Security benefits. If your combined income is above $34,000 then as much as 85% of your benefits could be taxable. For married couples filing jointly, those numbers are $32,000 and $44,000, respectively.
Here's an example: If you have $25,000 in adjusted gross income from a job, receive monthly Social Security benefits of $2,200 (or annual benefits of $26,400), and have no nontaxable interest, then your combined income would be $38,200 (25,000 + $26,400 x 50%).
As a result, half of the amount between $25,000 and $34,000 will go toward your taxable income ($4,500), and 85% of the amount above $34,000 will also count as taxable income ($3,570). In this example, about $8,070 of this retiree's Social Security benefits would count as taxable income. This is not the amount this person is paying in taxes.
How the COLA increase could hurt you
An 8% or 9% COLA increase is certainly not insignificant and could push more of your Social Security benefits into taxable income.
In the example above, where monthly Social Security benefits are $2,200, a 9% COLA increase would raise your monthly benefits by $198 to $2,398 and your annual benefits to $28,776. Add half of this ($14,388) to your adjusted gross income of $25,000 and your combined income is now $39,388.
Now, half of the combined income between $25,000 and $34,000 would be taxed ($4,500) plus 85% of the $5,388 above the $34,000 would also count toward taxable income ($4,580). So, your the taxable portion of your Social Security benefits would grow to $9,080, which is $1,010 more that will be counted as taxable income than the example above.
Something to keep in the back of your mind
The COLA increase will by and large be a positive thing for retirees in the Social Security program and it's needed as well because the cost of living is now much higher due to inflation.
But you'll want to keep these tax thresholds in mind and run some calculations to figure out how much more of your Social Security benefits will be taxed after the COLA increase. Knowing these figures is important because there are ways to lower the tax burden on your Social Security benefits, but you need to know where you stand before you can act.
