Will your Social Security benefits be taxed?

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For many people, the answer is yes — but these strategies could help you minimize the hit on your retirement income.

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After years of planning for that perfect retirement — diligently investing their money, drawing up detailed budgets and wisely investing assets — many investors continue to miss one important detail: As much as 85% of your Social Security income could be subject to federal income taxes (and you may also be subject to state and local income taxes). "That can be a real shock when people begin collecting benefits," says Ben Storey, director, Retirement Research & Insights, Bank of America.
How much of your Social Security income is subject to federal income tax depends on a variety of factors, including your federal income tax filing status and your modified adjusted gross income. But with a little up-front planning, which can include everything from rebalancing your portfolio to structuring certain transactions (such as the sale of a home or a business) in the right way, you may reduce the possibility of taxes derailing your plans.

How taxes are calculated

Social Security benefit taxes are based on what the Social Security Administration (SSA) refers to as your "combined" income. That consists of your adjusted gross income plus, nontaxable interest (and certain other items) and half of your Social Security income. After you cross the income thresholds specified in the chart below, a portion of your Social Security benefits will be considered taxable income. For example, a married couple in retirement filing jointly with combined income greater than $32,000 up to $44,000 could find that as much as 50% of their benefit payments are considered taxable income.
Combined income amounts for:
  Married, filing jointly Other taxpayers* Then:
Scenario one $32,000 or less $25,000 or less Social Security income is tax free
Scenario two Between $32,000 and $44,000 Between $25,000 and $34,000 Up to 50% of Social Security income is taxable
Scenario three More than $44,000 More than $34,000 Up to 85% of Social Security income is taxable
*If you are married, filing separately and do not live apart from your spouse at all times during the taxable year, up to 85% of your Social Security income is taxable. Source: Social Security Administration, https://www.ssa.gov, accessed Dec. 3, 2021

Build a long-term strategy

Because of these income thresholds, tax planning experts often advise looking for ways to lower your combined income. "When you plan for retirement," says Vinay Navani, a shareholder with WilkinGuttenplan, an accounting and consulting firm in East Brunswick, New Jersey, "you need to think in terms of multiyear projections." For example, if you anticipate a big one-time event, such as the sale of a business, you may be better off structuring the sale as an installment sale to be paid off over several years instead of an all-cash transaction. This can help evenly distribute your overall income and possibly keep you in a lower tax bracket, which could help reduce the portion of your Social Security benefits that is subject to federal income tax.
You may also want to consider a longer-term strategy for drawing from your individual retirement accounts (IRA). That's because withdrawals from a traditional IRA generally will be included in your federal taxable income. Qualified withdrawals from a Roth IRA, however, are generally not included in your federal taxable income. So if you have both, you may want to carefully consider whether you should make withdrawals from your Roth or traditional IRA first.
A word of caution if you are considering converting a traditional IRA to a Roth IRA: Any deductible contributions you convert will be included in your federal ordinary income in the year of the conversion. That may be worth it, though, because of the Roth IRA's other tax advantages. (Note, too, that the rules around Roth IRA conversions may change under the tax framework currently under consideration by Congress.)
Another option is to sell a non IRA investment that earns taxable income, such as a taxable bond portfolio, and purchase a tax-deferred account, such as a deferred annuity. You could structure the annuity to begin paying income in a few years, when you expect your federal taxable income, as well as your overall tax rate, to decline.
If you're earning income in retirement, you may still be eligible to contribute to an IRA — and contributions to a traditional IRA may be tax deductible, lowering your taxable income.

Know the earnings limits

Those hoping to work in retirement need to be especially careful if they're planning to claim Social Security benefits early. Even if you're just working part-time, it's important to consider how that continuing income will affect your benefits.
The SSA caps how much you are allowed to earn if you start taking your benefits before full retirement age, which is 66 for most baby boomers. For the most recent annual earned income cap, view the current annual contribution limits. For every $2 you earn over the limit, the SSA withholds $1 off the top of your benefits. Once you reach the year that you'll turn full retirement age, the earned income cap goes up, and for every $3 you go over, it's a $1 withholding during the months until your birthday.
There is some good news, however: Because the penalty is determined by your individual earned income, if you retire early but your spouse doesn't, your spouse's earned income will not be factored into the earnings limit. Additionally, in the month you reach your full retirement age, the earnings limit disappears and Social Security will recalculate your benefit amount if you were negatively impacted by the earnings limit.
Keep in mind, if you file your tax return jointly, your spouse's earnings will be included when calculating your combined income for purposes of determining the taxation of your benefits.Footnote 1

Forewarned is forearmed

Lastly, do a bit of homework. Worksheets in IRS Publication 915, "Social Security and Equivalent Railroad Retirement Benefits," available at www.irs.gov, can help you compute your tax liability. Then check with your state to see whether it taxes benefits. You might not be able to avoid tax liability, but at least you'll know what to expect and will be able to plan accordingly. As always, your financial advisor can work with your tax professional to find appropriate solutions.
Next steps

1 IRS Publication 915, Social Security and Equivalent Railroad Retirement Benefits, for use in preparing 2020 returns, page 3, https://www.irs.gov/pub/irs-pdf/p915.pdf

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This material should be regarded as general information on Social Security considerations and is not intended to provide specific Social Security advice. If you have questions regarding your particular situation, please contact your legal or tax advisor.

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