Many people enter the golden years of retirement completely unaware that a large portion of their Social Security benefits are going to be subject to tax. Even though the opportunity exists to have taxes withheld from Social Security benefits, most clients elect not to, and as a result some of them can find themselves owing Uncle Sam money at tax filing time.
Based on a pair of Treasury Tax Rulings issued in 1938 and 1941, Social Security benefits were explicitly excluded from federal tax. All of this changed in 1983, and beginning in 1984, up to 50 percent of an individual’s Social Security could potentially be subject to tax based upon income limitations.
In 1993, as part of Omnibus Budget Reconciliation Act, the Social Security taxation provision was modified to add a secondary set of thresholds and a higher taxable percentage of 85 percent for beneficiaries who exceeded the secondary thresholds.
How Social Security is Taxed
Essentially, Social Security is funded through payroll deductions paid by the employee and a matching contribution paid by the employer. A self-employed person pays both the employee and employer portion.
Additionally, a self-employed person deducts from income being taxed 50 percent of the social security tax paid. Social Security tax paid by a self-employed person is considered self-employment tax. The amount withheld from the employee is not excluded from wages for purposes of taxation and is therefore “taxed” money. The amount contributed by the employer is not includible in income and is therefore not taxed.
Typically, the amount an employee contributes to a retirement plan is contributed “pre” tax, and is therefore taxed upon distribution. Based on the method of contributions, it would stand to reason that approximately 50 percent of an individual’s benefits have already been taxed.
So why are some people paying tax on 85 percent of their benefits?
The original taxation of benefits was set at 50 percent based on the employee's portion already having been subject to tax. However, the 1993 Reconciliation Act changes were designed to bring the taxation of Social Security benefits in line with the tax treatment of private pensions where the real “non-contributed” portion is about 85 percent of the average benefit, not 50 percent.
If the total of your taxable pensions, wages, interest, dividends, and other taxable income, plus any tax-exempt interest income, plus half of your Social Security benefits are more than a base amount, some of your benefits will be taxable.
Benefits are taxed at either 50 or 85. The 50 percent base amount is $25,000 for singles and $32,000 for those who are married and filing jointly. Taxpayers whose base amount exceeds $34,000 for singles and $44,000 for married and filing jointly will pay tax on up to 85 percent of their Social Security benefits.
A critical step in planning regarding the taxation of Social Security benefits is the Federal Tax Table. For 2016, the single tax rate changes from 15% to 25% at $37,650. Married filing jointly taxpayers see the tax increase from 15% to 25% at $75,300. So, taxpayers with income in the higher bracket will not only suffer the insult of having their Social Security benefits taxed, but will be paying a 25% tax on their benefits.
As always, a challenging tax situation presents us with an opportunity to plan effectively and maximize deductions so that we can help our clients pay the minimum tax.
A tax preparer who works effectively with clients in their retirement years will review all income streams and potential deductions to minimize the taxability of Social Security benefits, and prepare clients for when Uncle Sam asks for a piece of their benefits.