What to know about Social Security benefits and your taxes

Federal income taxes are fairly straightforward for most people during their working years because their income is primarily derived from a paycheck. Income tax in retirement may get more complicated, however, because retirees often receive taxable income from multiple sources, including Social Security, with different tax characteristics.

Yes, a portion of your Social Security benefits may be subject to federal income tax. Up to 85% of your Social Security income may be subject to federal income tax, but you’ll need to do a calculation based on all of your income to determine the exact amount. The taxable portion depends on your income and filing status.

A calculated level of income (sometimes called “provisional” or “combined” income) is essentially half of your Social Security benefit plus other income, such as retirement plan distributions and any interest earned on municipal bonds.

Your Social Security benefits aren’t taxable below a certain threshold of provisional income. Once above that threshold, however, the Internal Revenue Service (IRS) has determined a graded scale of taxation.

Keep in mind that, some states make Social Security benefits taxable as well, meaning additional tax could be owed depending on your state of residence.¹

If some of your Social Security benefits are taxable (meaning your provisional income exceeds the threshold), the benefits are taxed based on your income within federal income tax brackets and the corresponding tax rates. However, the way Social Security benefits are taxed could increase your marginal tax rate. “Marginal tax rate” means the percentage of tax paid on your highest dollar of taxable income.

In some cases, those in the 22% federal income tax bracket could end up paying a marginal tax rate as high as 40.7% because additional household retirement income causes more of their Social Security income to become taxable. (See “Social Security income can raise your marginal tax rate.”)

People in the 10%, 12%, and 22% federal tax brackets could be affected by the high marginal rate, especially those with an above-average monthly Social Security benefit. If you’re part of this group, consider working with a tax professional to fine-tune your retirement expenses, taxable income, and tax projections. Doing so could help you determine whether additional planning or adjustments may be necessary.

In the example in figure 2 “Taxability of Social Security”, a married couple collects $76,000 a year in total annual Social Security income and their only other income is $70,000 of distributions from individual retirement accounts (IRAs). This makes their provisional income $108,000. At that level, they haven’t quite reached the 85% cap on taxability of Social Security.²

Now suppose they take an additional $1,000 in income from their IRA. The couple might expect to pay $220 more in taxes since they’ll be in the 22% bracket. However, since that $1,000 results in $850 more of their Social Security income being subject to tax, their tax bill increases by $407 (22% of $1,850). Their marginal tax rate is really 40.7% at this point, but at higher income levels, it eventually goes back down to 22%. If there are steps you can take to minimize the income taxed at this level, they are worth considering.

Since required minimum distributions (RMDs) may put you in this high marginal rate situation, it’s important to plan before reaching age 73. One strategy to consider is converting Traditional IRA assets to a Roth IRA. Converting at a relatively low tax rate early in retirement could reduce future RMDs that would push you into a higher income tax bracket and trigger the 40.7% marginal rate described above.

Having some financial flexibility can also help you limit your highly taxed income. If you think you could be subject to high marginal rates, you may want to fund additional spending needs with income sources that generate little or no taxable income. This could include drawing on your cash reserves or a Roth account or selling off investments with small gains. Consider the previous example: If you took the additional $1,000 of income from a Roth account instead of a traditional account, that $1,000 would not increase taxable income.

If you’re approaching the point where the maximum 85% of your Social Security income is taxable, you could take more taxable distributions once you pass the 85% cap. That would free up cash to use next year so that you might avoid the high marginal rate in that year.   

For many people, it’s best to delay claiming Social Security until full retirement age or later. Waiting as long as possible to claim benefits reduces the chances of outliving your money while also maximizing Social Security survivor benefits (if you’re the higher earner). While Social Security is part of a broader retirement income plan, taxes should be a secondary consideration. Remember that at least 15% of your Social Security income is exempt from federal income taxes no matter what.

Don’t be tempted to claim Social Security early just because you may be affected by higher marginal rates.

Like many financial aspects of retirement, taxes on Social Security benefits can be confusing. Fortunately, a little planning can prevent it from being a major problem.