Tax Man Flickr Shine
Don't let the tax man take more than his fair share. Image: Flickr user kev-shine.

Social Security benefits are an essential part of how retirees make ends meet, but one thing that shocks many Americans is that under certain circumstances, the payments they receive can be taxable income that they have to report on their tax returns. The formulas for determining your taxable Social Security benefits can be complicated, but with a bit of effort, you can figure out what your tax liability will be. In some cases, you can even take steps to reduce the amount of tax you'll owe on your benefits. Let's take a look at how to calculate your taxable Social Security benefits and what you might be able to do to ease your tax burden.

The (too) simple answer
At first glance, it seems as if figuring out your taxable Social Security benefit amount is fairly easy. The IRS lists income limits above which a portion of your Social Security will be subject to tax. For single recipients, income above $25,000 subjects as much as 50% of your benefits to taxation, while income above $34,000 leaves as much as 85% of your benefits subject to tax. For joint filers, the two analogous threshold amounts are $32,000 and $44,000, respectively.

The first complication comes in when you figure out income for purposes of Social Security taxation. In determining your income, you can start out by taking your ordinary taxable income from your tax return. But you also have to make a couple of additions. First, interest from municipal bonds, which is ordinarily tax-free at the federal level, is included in the income calculation. You also have to take one-half of your Social Security benefits and add it to the total in order to come up with your final income figure.

How "as much as" can mislead you
The key language in the IRS description of taxable Social Security benefits is that "as much as" 50% or 85% of your benefits can be subject to tax. However, that doesn't mean that as soon as you move a single dollar over the respective income thresholds that suddenly the full percentage of your benefits gets included in taxable income. Instead, the worksheet that the IRS has you complete in order to determine your taxable Social Security amount takes a more incremental approach to increasing your taxable income.

An example can make this a lot easier to understand. Say that you're single and had Social Security benefits of $15,000 and other income of $17,500. In that case, half of your Social Security comes to $7,500, which, when added to your other income, puts you right at the threshold of $25,000, so none of your benefits are taxable.

Now change that example slightly so that your other income rises by $1,000 to $18,500. That puts your total income for determining Social Security taxation at $26,000, or $1,000 above the threshold amount. When you run the numbers through the worksheet, you'll find that your taxable benefits come out to just $500 -- far less than the $7,500 that would represent 50% of what you got from Social Security.

What the worksheet shows is that even though up to 50% is subject to tax, the actual amount is typically 50% of your taxable Social Security income above the threshold. Put another way, you don't need to worry about the impact of a single dollar of income putting you above the threshold, because it will only add $0.50 of taxable income to your total. A similar situation applies to the higher threshold for 85% inclusion -- each dollar of income above the threshold puts another $0.85 into the taxable Social Security category, but you won't see any huge one-time impact simply by hitting that 85% line.

Lowering your taxes
Retirees have a bit of latitude in affecting whether their Social Security benefits will get taxed. By being smart about selling investments and taking taxable distributions out of IRAs and 401(k)s, you can have more or less taxable income that will count against you in determining taxable Social Security benefits. Taking advantage of eligible deductions can also help make less of your benefits taxable.

No one likes paying more taxes, but some of the misconceptions about taxable Social Security benefits are unnecessarily frightening. In many cases, the impact of the tax rules on your benefits will turn out to be smaller than you might expect.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.