Retirees rely on Social Security to help them make ends meet. Given that they already paid payroll taxes in order to earn their benefits, retirees often find it shocking when they discover that under certain circumstances, Social Security payments can be subject to income tax.
One of the most common reasons why retirees end up having to pay income tax on a portion of their benefits involves how they handle their tax-favored retirement accounts, such as IRAs and 401(k) plans from former employers. Depending on what you do with IRAs and 401(k)s, a situation that would otherwise leave your Social Security benefits completely untaxed could turn into a costly alternative that requires substantially higher tax payments to the IRS.
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The basics of taxing Social Security benefits
The laws governing taxation of Social Security benefits acknowledge the fact that most retirees live on fixed incomes and can't afford to lose a big portion of their benefits to taxes. That's why they use an income-based test in order to come up with how much of a person's benefits must get included in taxable income.
Calculating exactly how much money you have to include as taxable income is a bit complicated. To start out, retirees take their total income from all sources other than Social Security and add it up. Then, they have to put in one-half of their total Social Security benefits for the year. That comes up with an annual income number for purposes of determining whether any benefits will be taxed.
The chart below shows you what to do next. If the total is above the threshold in the 50% column, then up to half of your Social Security income can get taxed. If it's above the threshold in the 85% column, then even more of your Social Security is subject to taxation.
|
Filing Status |
50% Taxation Threshold on Social Security |
85% Taxation Threshold on Social Security |
|---|---|---|
|
Single, Head of Household, Qualifying Widow(er) |
$25,000 |
$34,000 |
|
Married Filing Jointly |
$32,000 |
$44,000 |
Data source: IRS.
The actual math involved is tricky, because these thresholds only give maximum taxable amounts. The exact amount depends on how much above the thresholds your income is, as well as how much you earn in benefits from Social Security.
The danger from tax-favored retirement accounts
Most people don't end up paying tax on any of their Social Security, and the reason is pretty simple: They don't have outside sources of income that can push them over the thresholds. If your only source of income is Social Security, then because of the way the formula works, there's just about no way to get enough in benefits to make any of them taxable. Spending down savings in regular taxable accounts has little impact, because those savings don't produce taxable income.
However, withdrawals from retirement accounts like IRAs and 401(k)s present a big challenge. For traditional IRAs and 401(k)s, those withdrawals are treated as income for tax purposes, meaning that retirees typically have to pay taxes on what they take out of their retirement accounts. That in turn boosts the total income figure that determines whether Social Security benefits get taxed.
That holds true regardless of the reason for the withdrawal. Taking money for living expenses, taking a lump-sum distribution from a retirement account without rolling it over, or even making withdrawals to help you cover the tax liability of having to pay income tax on distributions all potentially adds to your total income for Social Security tax purposes.
Escaping the tax trap
To avoid this problem, many retirees find that having Roth-style retirement accounts can be quite helpful. Although traditional retirement accounts are problematic, distributions from Roth IRAs and Roth 401(k) accounts don't have a negative impact on Social Security taxation. So if you have Roth-style accounts, using them can be to your advantage.
Absent using Roths, the key thing retirees have to remember is that withdrawing money from retirement accounts can lead to higher taxes. That doesn't mean you shouldn't take money out of IRAs and 401(k)s, but it does mean that tapping all your financial resources in a balanced fashion could be better to keep your Social Security from going to the IRS.
