Surprise! Do your clients know how Social Security income is taxed?
“Making friends.” “Being busy.” “Spending more.” “Missing work.”
Ask retirees what has surprised them about retirement and you can expect responses such as those.
What goes unmentioned, though, may be a surprise that comes at tax time. It is the discovery that, for the majority of recipients, taxes are owed on Social Security benefits.
Originally, Social Security payments were tax-free to all retirees. Over time, however, “means” testing was introduced. It now renders those payments into federally taxable income for most recipients.
What is new news to some recent retirees is old news to the IRS. Regardless, the good news is clients can consider measures to ease the tax bite on their Social Security benefits.
Tax treatment through the years
Back in 1937, when the first retirement checks were issued, Social Security benefits were excluded from a recipient’s gross income. That benign tax treatment continued for more than four decades.
Beginning in 1984 however, as mandated by the Social Security Amendments of 1983, a portion of Social Security benefits for certain individuals became subject to federal income taxes.
Washington acted in response to the work of the National Commission on Social Security Reform. Charged with studying the program’s long-range financing problems, the Commission issued a series of recommendations. Among them was “Inclusion of up to 50% of Social Security benefits in the taxable income of higher-income beneficiaries” (emphasis mine).
“Higher income” (based on income from specified combined sources) was delineated as singles (individual tax filers) earning at least $25,000 and married couples (joint tax filers) earning at least $32,000.
Congressional tax writers revisited Social Security benefits a decade later. As part of the Omnibus Budget Reconciliation Act of 1993, Social Security taxation was modified to add a secondary, higher set of income thresholds. At the same time, a new, higher taxable percentage was established for beneficiaries who exceeded the secondary income thresholds.
As a result, up to 85 percent of Social Security benefits were included in the taxable income of single filers earning more than $34,000 and of joint filers earning more than $44,000.
The following table overviews the current tax treatment of Social Security benefits.
Trapped in time
Do you know anything that costs the same as it did in 1993, much less 1984? Neither do I.
But the income ranges that determine Social Security taxation were established in those years. Today, decades later, those thresholds have never been adjusted for inflation. Recall, the original intent was to tax the benefits of only “higher-income” beneficiaries. However, no provision then was made for indexing the earnings amounts and no legislation since has updated them.
As a result, according to the Social Security Administration1:
- “The proportion of beneficiary families whose benefits are taxed has increased from less than one in 10 [in 1984] to more than half.”
- “Projections show that an annual average of about 56 percent of beneficiary families will owe federal income tax on their benefits from 2015 through 2050.”
Remember, Social Security benefit taxation begins at as little as $25,000 in income for a single tax filer and $32,000 in earnings for joint tax filers. Now consider that the median retirement income for a household headed by someone aged 65 to 74 is $47,432. And the median retirement income for a household headed by someone aged 75 and older is $30,635.2 The result: As incomes have increased over time, more and more retirees have seen their Social Security benefits subjected to taxation.
Components of ‘provisional’ income
Social Security benefit taxation is based on a tax filer’s “provisional income” for the year. Provisional income, in turn, according to the law generally includes:
- earned income
- taxable income from pensions, 401(k)s and IRAs
- taxable interest, dividends and distributions
- tax-exempt interest (such as interest from a municipal bond) and
- 50% of Social Security benefit
Once the components of a client’s provisional income are identified and totaled, you then can determine into which of three provisional income brackets the client falls.
Next page: Ways to increase Social Security benefits
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