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The Outrageous Effect of Taxation of Social Security Benefits

July 09, 2020
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As you may be well aware, Social Security retirement benefits can be taxable to you, depending upon how much other income you have. What you may not be aware of is how this can seriously increase your taxes for small amounts of additional income.

Provisional Income

First – in order to calculate how much of your Social Security benefit is taxable, it is necessary to determine the amount of your “provisional income” – which is your Modified Adjusted Gross Income (MAGI) plus 1/2 of your Social Security benefit plus any tax-exempt income you’ve received. If you are married and filing jointly (MFJ) and this amount is greater than $32,000, at least part of your Social Security benefit is taxable. The lower limit for all other filing statuses – single, head of household, qualifying widow(er) and married filing separately while living apart from your spouse – is $25,000. If your filing status is married filing separately and you continue to live with your spouse, the lower limit is zero.

The amounts mentioned above are just the first limit – if your provisional income is above those levels, up to 50% of your Social Security benefit is taxable – that is, added to your gross income. If the provisional income is above $44,000 and your filing status is MFJ, then up to 85% of your Social Security benefit becomes taxable. For all other statuses, provisional income above $34,000 triggers up to 85% taxability on your Social Security Benefit. It’s actually not always fully 85%; rather, it’s 85% of the amount that you’re over the limit or 85% of your Social Security benefit, whichever is less. (see the example below)

 

The Effect

Where this really hurts folks is when provisional income is just barely above the upper limit.  See the example below – this is a married couple who earn a total of $40,000 in income (MAGI), plus a total of $16,000 in Social Security benefits:

Modified Adjusted Gross Income

$40,000

Plus 1/2 of Social Security Benefit

$8,000

Provisional Income

$48,000

Less base amount

$44,000

Excess above base

$4,000

85% of excess

$3,400

Plus 50% of the excess above the first base ($6,000)

$9,400

85% of Social Security Benefit

$13,600

To include in gross income (lesser of previous two above)

$9,400

New Gross Income

$49,400

 

So now watch what happens if these folks earn $1,000 more:

Modified Adjusted Gross Income

$41,000

Plus 1/2 of Social Security Benefit

$8,000

Provisional Income

$49,000

Less base amount

$44,000

Excess above base

$5,000

85% of excess

$4,250

Plus 50% of the excess above the first base ($6,000)

$10,250

85% of Social Security Benefit

$13,600

To include in gross income (lesser of previous two above)

$10,250

New Gross Income

$51,250

 

Normally, when someone of this income level (12% tax bracket) increases their income by $1,000, their tax would only increase by $120 – as you might expect. But with this tax on Social Security benefits based upon the provisional income that you bring in, with an addition of only $1,000 to their annual income, their gross income is effectively increased by $1,850. As a result, this $1,000 increase in income has caused an increase in tax of $222 – for a rate of 22.2% on that $1,000 increase! These Thresholds are often referred to as the Social Security Tax Torpedo.  That tax money is often taken from an IRA, causing it to shrink more quickly than folks may have planned.

As another example, when you go over the first threshold for every dollar extra you have it causes $1.50 to be taxed and once you go over the second threshold for every dollar extra you have it causes $1.85 to be taxed.  So, if you are in 25% tax bracket you are paying 37.5 cents in tax per dollar above the first threshold (37.5% effective tax) and 46 cents on every dollar above the second threshold (46% effective tax)  (at a 33% tax bracket it is 49.5% and 61% effective tax).

As you can see, this can be an outrageous impact on financial livelihood. I’ve run the numbers many times, and this can mean an extra 5-6 years of retirement income going to taxes.  This is another reason to work now to get yourself tax-free in retirement!