The Social Security Tax Surprise: Understanding What You'll Really Keep

Retirement is often the longest period of unemployment in our lives. To fund retirement years, many of us rely on a combination of 401k withdrawals and Social Security income. However, one critical factor is frequently overlooked, and that is taxes.

Many retirees are surprised to learn that up to 85 percent of Social Security benefits can be included in taxable income. This does not mean that Social Security is taxed at an 85 percent rate. Instead, it means that as much as 85 percent of the benefit may be subject to income tax, depending on how retirement income is structured. Ignoring this can significantly reduce the longevity of retirement assets.

In this article, we will discuss how Social Security taxation works and how planning income sources can help control how much of your Social Security becomes taxable.

To better understand this topic, we will cover the following:

• Provisional income and how it is calculated
• How provisional income determines Social Security taxation
• Two different retirement income scenarios

Provisional income and how it is calculated

Provisional income is a term used in the U.S. federal tax system to determine how much of your Social Security benefits are taxable. It is calculated using the following steps.

First, start with your Adjusted Gross Income. This includes wages from any part time work, 401k withdrawals, dividends, interest, rental income, capital gains, and other taxable income.

Second, add any tax exempt interest. This commonly comes from municipal bonds or other investments that are exempt from federal income tax. Even though this interest is not taxed, it is still included when calculating provisional income.

Third, add half of your Social Security benefits.

The total of these three components determines your provisional income.

How Provisional income determines Social Security Tax

Let's look at the relation between provisional income and how the social security money is taxed.

So, for married joint filers, if the provisional income is more than $44k, then, 85% of Social Security is taxed.

Two different retirement scenarios

Let's take an example of a couple that needs $100k yearly to live comfortably during retirement. This includes medical expenditure as well.

Let's see what happens if they plan their retirement funds like below.

Scenario 1

In this scenario, the couple funds retirement income as follows:

• 40,000 dollars from 401k withdrawals
• 5,000 dollars from municipal bond interest
• 20,000 dollars from Social Security benefits
• 35,000 dollars from rental income and dividends from stocks and mutual funds

Provisional income is calculated as:
40,000 plus 5,000 plus 10,000, which is half of Social Security benefits, plus 35,000. This results in a provisional income of 90,000 dollars.

Because provisional income exceeds 44,000 dollars, up to 85 percent of their Social Security benefits may be included in taxable income. In addition, most of their income sources are taxable, which increases their overall tax burden.

Scenario 2

In this scenario, the same couple structures their retirement income differently:

• 10,000 dollars from 401k withdrawals
• 5,000 dollars from municipal bond interest
• 20,000 dollars from Social Security benefits
• 5,000 dollars from dividends
• 10,000 dollars from a Health Savings Account used for qualified medical expenses
• 25,000 dollars from a Roth IRA
• 25,000 dollars from cash value life insurance accessed properly

Distributions from an HSA used for qualified medical expenses are not taxable. Roth IRA withdrawals and properly structured life insurance distributions are funded with after tax dollars and are not included in taxable income. These sources also do not factor into the provisional income calculation.

Provisional income in this case is calculated as:
10,000 plus 5,000 plus 10,000, which is half of Social Security benefits, plus 5,000 from dividends. This results in a provisional income of 30,000 dollars.

Because provisional income is below 32,000 dollars, none of the Social Security benefits are taxable.

Conclusion

In both scenarios, the couple funds the same 100,000 dollar retirement lifestyle. The difference lies in how the income is sourced. By using tax advantaged accounts and thoughtful income planning, retirees can significantly reduce or eliminate the taxation of Social Security benefits.

It is also important to note that in the first scenario, not only is provisional income higher, but overall taxable income is also much higher. Proper retirement tax planning does not happen in a few days or months. It is a long term strategy that benefits those who start early.

The sooner retirement planning begins, the more control you gain over taxes in retirement.

That is a wrap for this week. Happy learning!