Understanding the Financial Basics of How Social Security is Taxed
The first step in minimizing taxes on your benefits is to understand how the IRS determines if you owe taxes in the first place. It all comes down to a special calculation called your “combined income” (sometimes referred to as “provisional income”). This isn’t a number you’ll find on your tax forms; you have to calculate it yourself. Don’t worry, the formula is straightforward.
Your Combined Income = Your Adjusted Gross Income (AGI) + Nontaxable Interest + 50% of Your Social Security Benefits
Let’s break that down:
- Adjusted Gross Income (AGI): This includes all your taxable income sources, such as wages from a part-time job, withdrawals from a traditional IRA or 401(k), pension payments, dividends, and capital gains. It’s your gross income minus certain adjustments.
- Nontaxable Interest: This is typically interest earned from tax-exempt municipal bonds. While you don’t pay tax on this interest, the IRS still includes it in this specific calculation.
- 50% of Your Social Security Benefits: You simply take the total amount of Social Security benefits you received for the year and divide it by two.
Once you have your combined income total, you compare it to two specific thresholds set by the IRS. These thresholds determine what percentage of your benefits, if any, will be considered taxable income.
Tax Thresholds for Single Filers
If you file your taxes as an individual, these are the income brackets you need to know:
- If your combined income is $25,000 or less: Congratulations! Your Social Security benefits are not taxable.
- If your combined income is between $25,001 and $34,000: Up to 50% of your Social Security benefits may be subject to income tax.
- If your combined income is more than $34,000: Up to 85% of your Social Security benefits may be subject to income tax.
Example: Let’s say you are single and receive $18,000 in Social Security benefits per year. You also withdraw $15,000 from your traditional IRA. You have no other income. Your AGI is $15,000. To find your combined income, you take your AGI ($15,000) and add half of your Social Security ($9,000). Your combined income is $24,000. Since this is below the $25,000 threshold, none of your Social Security benefits are taxed.
Tax Thresholds for Married Couples Filing Jointly
If you and your spouse file a joint tax return, the income thresholds are higher:
- If your combined income is $32,000 or less: Your Social Security benefits are not taxable.
- If your combined income is between $32,001 and $44,000: Up to 50% of your Social Security benefits may be subject to income tax.
- If your combined income is more than $44,000: Up to 85% of your Social Security benefits may be subject to income tax.
Example: Let’s imagine a married couple receives a combined $30,000 in Social Security benefits. They also have $20,000 in pension income. Their AGI is $20,000. Their combined income is calculated as their AGI ($20,000) plus 50% of their Social Security benefits ($15,000), which equals $35,000. Because $35,000 falls between the $32,001 and $44,000 thresholds, up to 50% of their benefits will be included in their taxable income.
It’s important to note that “up to 85%” does not mean you pay an 85% tax rate on your benefits. It means that up to 85% of your benefit amount is added to your other income, and that total amount is then taxed at your regular income tax rate.
