The Outrageous Effect of Taxation of Social Security Benefits

As you may be well aware, Social Security retirement benefits can be taxable to you, depending upon how much other income you have.  What you may not be aware of is how this can seriously increase your tax rate for small amounts of additional income.centralparkbySeamusMurray_thumb

Provisional Income

So – in order to calculate how much of your Social Security benefit is taxable, it is necessary to determine the amount of your “provisional income” – which is your MAGI plus 1/2 of your Social Security benefit plus any tax-exempt income you’ve received.  If you are married and filing jointly (MFJ) and this amount is greater than $32,000, at least part of your Social Security benefit is taxable.  The lower limit for all other filing statuses – single, head of household, qualifying widow(er) and married filing separately while living apart from your spouse – is $25,000.  If your filing status is married filing separately and you continue to live with your spouse, the lower limit is zero. The amounts mentioned above are just the first limit – if your provisional income is above those levels at least 50% of your Social Security benefit is taxable – that is, added to your gross income.  If the provisional income is above $44,000 and your filing status is MFJ, then 85% of your Social Security benefit becomes taxable.  For all other statuses, provisional income above $34,000 triggers 85% taxability on your Social Security Benefit.  It’s actually not always fully 85%; rather, it’s 85% of the amount that you’re over the limit or 85% of your Social Security benefit, whichever is less. (see the example below)

The Effect

Where this really hurts folks is when provisional income is just barely above the upper limit.  See the example below – this is a married couple who earn a total of $40,000 in income, plus  a total of $16,000 in Social Security benefits:
Modified Adjusted Gross Income $40,000
Plus 1/2 of Social Security Benefit $8,000
Provisional Income $48,000
Less base amount $44,000
Excess above base $4,000
85% of excess $3,400
85% of Social Security Benefit $13,600
To include in gross income (lesser of previous two above) $3,400
New Gross Income $43,400
So now watch what happens if these folks earn $1,000 more:
Modified Adjusted Gross Income $41,000
Plus 1/2 of Social Security Benefit $8,000
Provisional Income $49,000
Less base amount $44,000
Excess above base $5,000
85% of excess $4,250
85% of Social Security Benefit $13,600
To include in gross income (lesser of previous two above) $4,250
New Gross Income $45,250
Normally, when someone of this income level (15% tax bracket) increases their income by $1,000, their tax would only increase by $150 – as you might expect.  But with this provision to tax Social Security benefits based upon the provisional income that you bring in, when they add $1,000 to their annual income, their gross income is effectively increased by $1,850.  As a result, this $1,000 increase in income has caused an increase in tax of $277.50 – for a rate of 27.75%! As you can see, for folks that are right in the edge of these taxation limits, this can be an outrageous impact on financial livelihood.  If you happen to be in this position, it might be helpful to plan income (if you can) so that in one year you might not be impacted as much by this taxation, and then take the tax hit the following year.  This can only be accomplished if you are somewhat in control of when you earn income or recognize gains. As your MAGI increases, this effect becomes less and less, but it still is worth paying attention to – if you can plan around it, you might save yourself some extra tax!
Photo by Seamus Murray
IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

About the author

Jim Blankenship, CFP®, EA

Jim Blankenship is the founder and principal of Blankenship Financial Planning, Ltd., a financial planning firm providing hourly, as-needed financial planning and advice. A financial services professional for over 25 years, Jim is a CFP professional and has earned the Enrolled Agent designation, a designation that qualifies him as enrolled to practice before the IRS. Jim is also a NAPFA-registered financial advisor, which designates him as a Fee-Only Financial Advisor.

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