SOCIAL SECURITY IS the most important source of income for many retirees. Yet there’s also a lot of confusion, especially when it comes to how benefits are reduced if you continue working and how benefits are taxed. In fact, I’ve heard many folks confuse and conflate these two separate issues.
Want a refresher? Here’s a look at both topics:
Working while collecting. If you start Social Security benefits before you reach your full retirement age (FRA), which is age 66 or 67 depending on the year you were born, your benefits are reduced—or withheld, as the Social Security Administration terms it—if you earn “too much.”
In 2020, the maximum you can earn without any reduction is $18,240. If you earn more than $18,240, you would lose $1 in benefits for every $2 you earn above $18,240. Suppose you have a $2,000 monthly benefit. If you made $66,240, you’d lose all benefits for the year. For this so-called earnings test, the allowable earnings are adjusted each year for inflation.
There’s a special rule for the first year you start collecting Social Security. Let’s say you retire mid-year and you’ve already earned more than 2020’s $18,240 limit. Under the special first-year rule, you can get a full Social Security check for any whole month you’re retired, regardless of your earnings earlier in the year. As long as your monthly earnings are less than that year’s maximum monthly earnings, you get your full check. In 2020, the maximum monthly earnings are $1,520, equal to $18,240 divided by 12 months.
The government also cuts you some slack in the year you reach your FRA. In that year, you could earn $48,600 in 2020 without any reduction. Above $48,600, you would lose $1 in monthly benefits for every $3 you earn above $48,600, up until the month you reach your FRA. Once you reach your FRA, you can earn as much as you want without any reduction in your monthly benefit.
What counts as earnings? Social Security includes the wages you make from your job or your net profit if you’re self-employed. Also included are bonuses, commissions and vacation pay. What about pensions, annuities, investment income and other government benefits, such as military retirement benefits? Those don’t count.
The benefits that were withheld aren’t necessarily lost forever. Once you reach your FRA, your monthly benefit is adjusted upward to reflect the benefits surrendered over the prior years. But the withheld benefits aren’t returned right away. Instead, they’re spread over your expected lifetime.
Taxing times. I’ve met many seniors who are surprised that a portion of their Social Security benefits can be taxed. Since 1983, up to 50% of benefits are taxed. Legislation enacted in 1993 increased the portion of benefits that could be taxed to a maximum 85%. This is regardless of your age, and it’s determined solely by your income level and filing status.
The notion seems straightforward, but it’s a little tricky in practice. For each filing status, there are two thresholds that determine how much is taxable. The tables below show the thresholds for taxpayers who are single and married filing jointly. These thresholds aren’t indexed for inflation, which means that with every passing year Social Security taxation is becoming an issue for more retirees.
Consider a married couple with “combined income” of $31,000, which consists of $11,000 in IRA withdrawals and $40,000 in Social Security benefits. Yes, I know that sounds odd, but I’ll explain in a minute.
As you’ll see from the table above, this $31,000 in combined income falls within the 0% box, so their $40,000 in Social Security benefits aren’t taxed. On the other hand, if their combined income was $38,000, that would put them in the middle of the 50% box. Because $38,000 is $6,000 more than the $32,000 threshold, 50% of that $6,000 would be taxable. Result: $3,000 of their $40,000 in Social Security would be hit with federal income taxes.
What if their combined income was $46,000? That would not only fully use up the 50% taxation zone—which spans $12,000 from $32,001 to $44,000—but also puts them $2,000 over the $44,000 limit and hence in the 85% zone. Result? First, you take 50% of $12,000, which is $6,000. Next, you calculate 85% of the $2,000 above $44,000, which is $1,700. Add together those two amounts ($6,000 plus $1,700) and you find that $7,700 of their $40,000 in Social Security benefits would be taxable income.
Got all that? Now comes an even trickier part: calculating your combined income. The Social Security Administration defines combined income as adjusted gross income, plus nontaxable interest from municipal bonds, plus half of your Social Security benefit.
In practice, it’s a bit more complicated than this equation implies. IRS Form 1040 has a worksheet that’ll do it for you. It requires your income sources from your 1040 (wages, interest, dividends, pensions, IRA withdrawals and so on), as well as the additional income sources from Schedule 1. You can reduce your combined income with adjustments listed on Schedule 1.
Understanding how this works may open up some tax planning opportunities. Consider the couple in the example above, with their combined income of $46,000. For simplicity’s sake, assume they have just two income sources: their $40,000 in Social Security benefits and $26,000 in traditional IRA withdrawals. Recall that only half of their Social Security is used in calculating combined income and thus, while their total income might be $66,000, their combined income for purposes of Social Security taxation is just $46,000. Also recall that $7,700 of their Social Security is taxable.
What if they needed $5,000 in additional income? If they took further money from their traditional IRA, that would increase their combined income by $5,000—causing an additional $4,250 of their Social Security benefits to count as taxable income. The upshot: A $5,000 taxable IRA withdrawal turns into $9,250 of extra taxable income. What to do? If it’s an option, our couple might tap their Roth IRA instead or, alternatively, opt to sell taxable account investments with little or no embedded capital gains.
Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. Rick enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. His previous articles include Margin of Safety, State of Taxation and Paradise Lost. Follow Rick on Twitter @RConnor609.