Social Security Tax Liability
Posted on March 1, 2016 by bob in Financial, MoneyWise, Social Security
Despite tax software ads on TV, understanding income taxes for planning purposes can be difficult. 
Sometimes the income tax results can be peculiar if not downright perverse. To illustrate the point and alert the unwary, consider the federal income tax treatment of Social Security benefits. (Fortunately, Social Security benefits are not subject to Alabama income tax.)
First, the federal tax table is progressive—the applicable tax rate gets higher as one’s income rises. Here are the first three brackets for taxable ordinary income in 2016. (Be aware that the ranges change annually and that higher income is taxed at even higher rates.)
Tax Rate Single Joint
10% First $9,275 First $18,550
15% $9,276-37,650 $18,551- 75,300
25% $437,651-91,150 $75,301-151,900
In addition, long-term capital gains and qualified dividends are taxed at 0% for filers in a 15% or lower ordinary income bracket, and at 15% for all other filers not in the maximum 39.6% ordinary income bracket.
Second, the amount of Social Security benefits that are taxed depends on what the IRS calls “provisional income” (PI). PI is essentially one’s adjusted gross income (AGI) without Social Security benefits, plus tax-exempt interest from municipal bonds, plus half of Social Security benefits received. Here’s how much of a filer’s Social Security benefits are taxable based on PI.
Taxable Portion Single Joint
0% Up to $25,000 Up to $32,000
50% $25,000-34,000 $32,000-44,000
85% More than $34,000 More than $44,000
Now consider what happens as a result of the interplay among the usual tax rates and Social Security tax-inclusion rules. Suppose that you are married filing jointly and report $26,000 in Social Security benefits plus $20,000 of other income, perhaps from a pension. Your PI is $33,000 and just $500 of your SS benefits is taxable. Your AGI is $20,500 and thanks to personal exemptions and a standard deduction, you owe no federal tax.
What happens if you also withdraw $25,000 from an IRA and sell an asset that triggers a $25,000 long-term capital gain? Well, your actual income goes up by $50,000, but your AGI jumps by $71,600 because 85% of your Social Security is now taxable. That also means that you are no longer in a 15% or lower tax bracket and the long-term capital gain is now taxable. Your federal tax climbs from zero to $6,033.
Here are three planning points to keep in mind.
1. Anticipate your probable cash needs for several years in advance so that you do not have to generate cash from taxable sources in years when the tax consequences are higher than necessary.
2. If appropriate, spread your taxable income across multiple years while staying below higher tax thresholds. Don’t assume this will help; make sure before you act.
3. If you will be above a tax threshold in a particular year anyway, consider taking more than you need for that year’s expenses if it will allow you to stay below tax thresholds for multiple years thereafter. For instance, in the example above, taking the IRA withdrawal in one year and the capital gain in the next would have triggered $7,123 in taxes, $1,090 more than taking both in the same year. By spreading the extra income across two years, the Social Security inclusion rate increases in both years triggering more tax.
As illustrated in this article, withdrawals from non-Roth retirement accounts and the sale of assets that trigger long-term capital gains are prime examples of ways you can control the timing of taxable income recognition. Social Security income tax management certainly illustrates the expression, “Timing is everything,” and serves as yet another example of why it pays to plan! (4177146-01-16)
Alan Wallace
Alan Wallace, CFA, ChFC, CLU, is a Senior Private Wealth Advisor for Ronald Blue & Co.’s Montgomery office, www.ronblue.com/location-al. He can be reached at 334-270-5960, or by e-mail at alan.wallace@ronblue.com.
