How to Avoid the Social Security Tax Trap

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How to Avoid the Social Security Tax Trap

What Is Social Security Income?

Social Security is a program that provides insurance benefits. President Franklin D. Roosevelt founded it in 1935. People contribute to the program via payroll deductions or other means. The Social Security Administration manages the program (SSA).

Individuals may get Social Security payments in three categories:

  • Individuals contribute to the Social Security program via payroll deductions and income taxes. The amount is determined by the top 35 years of earnings and when the individual decides to claim their benefits. People who have contributed to the program for at least ten years are eligible to receive benefits when they reach the age of 62. When a person achieves full retirement age, which is either 66 or 67 depending on the individual’s birth date, full retirement benefits are provided. Individuals who wait until they are 70 years old to collect benefits might boost the amount of their retirement payment.
  • Handicap benefits: This section of the program compensates those who are unable to work due to a physical or mental disability. Conditions are being evaluated and are anticipated to endure more than a year, if not result in death. Family members may be eligible as well. People who apply for disability payments must fulfill certain wage requirements.
  • Survivor benefits: These are payments made to the spouses, children, and other dependents of deceased Social Security beneficiaries. Survivors must apply for benefits in specific situations, such as if they receive payments or if benefits are not automatically handed out.

If you receive Social Security payments, you may be wondering how much of your income is taxed. Your Social Security payments are combined with other taxable income at a rate of 85%, 50%, or zero, depending on the amount of your benefits and other income, including tax-free interest on municipal bonds and certain other excludable sums. Everything is dependent on the efforts you take to decrease your tax liability. Continue reading to learn ways to reduce your Social Security Income tax obligation.

Key Takeaways

  • Social Security payments are taxed in the same way as other taxable income at a rate of 85%, 50%, or zero.
  • If your income is less than $32,000 (married filing jointly) or $25,000 (single, heads of household, qualified widow(er), or married filing separately when spouses lived apart for the whole year), your benefits are not taxed.
  • Individual filers may be required to pay income tax on up to 50% of their benefits if their income is between $25,000 and $34,000. If your income exceeds $34,000, up to 85% of your benefits may be taxed.
  • If their total income is between $32,000 and $44,000, taxpayers who file a joint return may be required to pay income tax on up to 50% of their benefits. If your income exceeds $44,000, up to 85% of your benefits may be taxed.
  • Check with the tax department in your state to discover whether you must pay state taxes on your Social Security payments.
  Tax-Efficient Fund

Calculating Social Security Income Taxes

To determine whether your Social Security payments are partly or completely tax-free, you must use calculations specific to this conclusion. Add all of your:

  • Gross income after certain deductions. This is the amount from Form 1040, line 21. In addition to employer-provided adoption benefits, foreign earned income or foreign housing, and income earned by residents of American Samoa or Puerto Rico, be careful to include any revenue exempt from interest on U.S. savings bonds that was utilized for higher education.
  • 50% of your Social Security benefits This is the amount shown on Form SSA-1099, Social Security Benefit Statement, which the Social Security Administration sends to you by the end of January following the year in which benefits were received. The benefits are the gross amount indicated in box 3 for income tax purposes, not the net amount you got after Medicare premiums were deducted.
  • All interest is tax-free. Line 8a of Form 1040 shows interest on municipal bonds.

Your Base Amount

Compare the findings to the following base amount for your filing status:

  • if married filing jointly, $32,000
  • $25,000 if you are single, head of home, qualified widow(er), or married filing separately and your spouses lived apart for the full year.

Your Tax Liability

If the income mix you calculated previously is equal to or more than your base amount, you must evaluate whether 50% or 85% of benefits are includible. This is how it works:

  • For married couples filing jointly, 50% of income between $32,000 and $44,000 is deductible; 85% of income above $44,000 is deductible.
  • For persons who are single, head of household, or an eligible widow(er) filing separately when spouses lived apart for the full year, 50% of benefits are includible if their income is between $25,000 and $34,000; 85% of benefits are includible if their income is more than $34,000.
  Net of Tax Definition

85% of benefits are includable for a married individual filing separately who did not reside away from their spouse for the whole year.

If you earn less than this amount, none of your benefits are taxed.

Special Considerations

If any of the following apply to your case, do not use the standard calculation:

  • You contributed to a deductible individual retirement account (IRA) and were covered by a qualifying retirement plan via your employer or self-employment. In this scenario, see IRS Publication 590-A’s worksheet.
  • You remitted any Social Security payments you received throughout the year, as detailed in IRS Publication 915.
  • You got rewards for an earlier year this year. You may make a lump-sum decision to minimize your taxable income for current year. Worksheets are available in IRS Publication 915.

Bunch Your Income

Because 85% of benefits are includible after you exceed the $44,000/$34,000 income level, you may choose to push or postpone income to another year.

For example, if you know your income will be over this level and want to convert a regular IRA to a Roth IRA this year, do so and pay the taxes on it. This will not result in any extra Social Security payments being included.

Because you have a Roth IRA rather than a regular IRA, you will not be compelled to take required minimum distributions (RMDs) in the future. This will keep your future revenue lower than it would have been without the conversion.

State Income Tax Rules

The federal income tax is not the only tax to consider. When it comes to Social Security, you must also account for state taxes.

By 2021, 13 states will have taxed Social Security benefits. Seven of these states—Connecticut, Kansas, Missouri, Nebraska, New Mexico, Rhode Island, and Utah—have high income criteria for taxation benefits, so your benefits may not be taxed even if you live there. Depending on your state, you may be able to reduce your tax bill via income or deductions. As an example:

  Can You Fund a Roth IRA After Filing Your Taxes?

  • Minnesota residents may be eligible for a benefit reduction depending on income limitations. Married couples filing jointly may qualify for a $5,240 deduction if their combined income is less than $79,480, while single filers and heads of households may qualify for a $4,090 deduction if their combined income is less than $62,090. Married couples filing separately who earn less than $39,740 may deduct $2,620.
  • North Dakota: You may deduct taxable benefits if your federal adjusted gross income (AGI) is less than $50,000 (single filers) or $100,000 (married filing jointly) (married filing jointly).
  • Vermont: Individuals who earn less than a specific amount are eligible for a partial or complete exemption from Social Security payments. This is a two-tier system for income under $34,000 for singles and $44,000 for married couples filing jointly.

The remaining 37 states have no state income tax and do not levy Social Security payments. Over a three-year period, West Virginia approved legislation exempting Social Security payments from personal income taxes. Beginning in 2020, 25% of benefits are exempt; 50% in 2021; and 100% in 2022 and afterwards.

The Bottom Line

If you’re thinking of retiring, you’ll need to think about a variety of things, including how you’ll make money. You may be eligible for Social Security payments if you have contributed to the program for at least ten years. But keep in mind that you will have to pay taxes on these advantages since they are considered income. This is in addition to any other income you may have. If you have any doubts about whether your Social Security payments are taxable, you should consult with a certified public accountant (CPA) or tax counselor who can run the figures for you.

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