How to Avoid the Social Security Tax Trap

How much of your Social Security income is taxable? Depending 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. It all depends on the steps you take to reduce your tax exposure.

What’s Included in Social Security Income

To know whether your Social Security benefits will be partially taxed or fully tax-free, you need to follow formulas unique to this determination. Add together 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.
• One-half of your Social Security benefits. This is 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. This is interest from municipal bonds listed on line 8a of Form 1040.

Compare the results to a “base amount” fixed for your filing status. If you fall below this amount, then none of your benefits are taxed:

• $32,000 if married filing jointly
• $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 determine whether 50% or 85% of benefits are includable.

• For married persons filing jointly, 50% is includable for income between $32,000 and $44,000; 85% is includable if income is more than $44,000.
• For those who are single, head of household, qualifying widow(er), and married filing separately where spouses lived apart for the entire year, 50% is includable if income is between $25,000 and $34,000; 85% of benefits are includable 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 includable.

Special Situations 

The usual computation isn’t used if you did the following:

• Made deductible IRA contributions, and you or your spouse were covered by a qualified retirement plan through your job or self-employment. (In this case, use the worksheet in IRS Publication 590-A.)
• Repaid any Social Security benefits during the year (explained in IRS Publication 915).
• 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.) 

Consider Bunching Income to Avoid the Tax Trap

Because 85% of benefits are includable once you pass the $44,000/$34,000 income threshold, it may be advisable to push or defer income to a particular year.

For example, if you know that your income is going to be above this threshold and you’re planning on converting a traditional IRA to a Roth IRA, make the conversion this year and pay the taxes on it. Doing so won’t result in any additional inclusion of Social Security benefits. Then, 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.

Take Note of State Income Tax Rules

Federal income tax isn’t the only tax to be concerned about. Thirteen states tax Social Security benefits; 37 do not (either because they have no state income tax or fully exempt Social Security benefits). However, of these 13 states, seven (Connecticut, Kansas, Missouri, Nebraska, New Mexico, Rhode Island, and Utah) have high-income thresholds for taxing benefits, so even if you are 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. These states use the federal determination. If you’re thinking of relocating in retirement, keep state income tax rules in mind when selecting your new location.

The Bottom Line

If you have any questions about whether your Social Security benefits are taxable, talk to your CPA or another tax advisor who can run the numbers for you.

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