Based on the amount of your Social Security benefits and other income–including tax-free interest on municipal bonds and certain other excludable amounts–your benefits are included with other taxable income at the rate of 85%, 50%, or zero. The rate depends on how you reduce your tax exposure.
To know if your Social Security benefits will be partially taxed or fully tax-free, you need to use these formulas. Add up your gross income with certain adjustments. This is the amount from line 21 of Form 1040. Then add back any excluded income from interest on U.S. savings bonds used for higher education purposes, employer-provided adoption benefits, foreign earned income or foreign housing and income earned by residents of American Samoa or Puerto Rico.
To see if 50% of your Social Security benefits are taxed, review the amount listed on Form SSA-1099, Social Security Benefit Statement, which is sent to you by the Social Security Administration by the end of January following the year in which benefits were paid. For income tax purposes, the benefits are the gross amount listed in Box 3, not the net amount you actually received after premiums for Medicare were withheld.
All tax-exempt interest is interest from municipal bonds listed on line 8a of Form 1040.
Look at the results compared to a “base amount” fixed for your filing status. If you’re below this amount, then none of your benefits are taxed:
- $32,000 if married filing jointly; or
- $25,000 if single, head of household, qualifying widow(er) and married filing separately, where spouses lived apart for the entire year.
If the income mix you figured earlier is equal to or above this base amount, then see if 50% or 85% of benefits is includible. For married persons filing jointly, 50% is includible for income between $32,000 and $44,000, and 85% is includible, if income is more than $44,000.
For singles, head of household, qualifying widow(er) and married filing separately, where spouses lived apart for the entire year, 50% is includible of income, if between $25,000 and $34,000, and 85% of benefits is includible, if income is above $34,000. For a married person filing separately who did not live apart from their spouse for the full year, 85% of benefits are includible.
There are also some special situations. The usual computation isn’t used if you:
- Made deductible IRA contributions and you or your spouse were covered by a qualified retirement plan through your job or self-employment. (Instead, use the worksheet in IRS Publication 590-A);
- Repaid any Social Security benefits during the year (see in IRS Publication 915); or
- Received benefits this year for an earlier year (You can make a lump-sum election that will reduce the taxable amount for this year. Use worksheets in IRS Publication 915).
Since 85% of benefits are includible, once you exceed the $44,000/$34,000 income threshold, it may be wise to defer income to a particular year. Say that you know your income is going to be above this threshold and you’re planning on converting a traditional IRA to a Roth IRA. You could make the conversion in this year and pay the taxes on it. This won’t result in any additional inclusion of Social Security benefits. As a result, in the future, you won’t have to take required minimum distributions (RMDs) because you have a Roth IRA, not a traditional one. This will keep your income lower in future years, than it would have been without the conversion.
Remember that your federal income tax isn’t the only tax to worry about. Thirteen states tax Social Security benefits. However, 37 states don’t (either because they have no state income tax or fully exempt Social Security benefits).
Among the 13 states, seven of them (Connecticut, Kansas, Missouri, Nebraska, New Mexico, Rhode Island, and Utah) have high-income thresholds for taxing benefits. So, even if you’re a resident, your benefits may not actually be taxed.
However, if you live in Minnesota, North Dakota, Vermont, or West Virginia—and your benefits are taxable for federal income tax purposes—they’re automatically taxable for state income tax purposes. This is because these states use the federal determination. Remember this, if you’re thinking of relocating in retirement.
Talk with an estate planning attorney, if you have questions about whether your Social Security benefits are taxable and how this may impact your retirement and estate planning.
Reference: Investopedia (March 13, 2018) “How to Avoid the Social Security Tax Trap”