Social Security Demystified: Calculating Taxation, Provisional Income, and the Tax Torpedo

Listener Michael asks about how Social Security is taxed, the rationale behind the 50% and 85% tax thresholds, and the implications of these taxes on Social Security and IRA withdrawals.

James responds by explaining how Social Security is taxed at the federal level, highlighting the concept of provisional income and the thresholds that determine the taxability of benefits. He notes state taxation of Social Security, explaining that most states do not tax these benefits and naming the ones that do. 

He also explains practical strategies for managing Social Security taxes, including the Social Security tax torpedo, and how to incorporate these considerations into broader retirement and tax planning.

Questions answered:
How is Social Security income taxed at the federal level, and what are the provisional income thresholds?

What is the Social Security tax torpedo, and how does it impact the effective tax rate on retirement income?

Timestamps:
0:00 - Michael’s question
1:06 - How SS is taxed
3:15 - Provisional income thresholds 
5:21 - Another example
7:13 - Thresholds for married filing jointly
8:41 - SS state taxes
9:59 - How to pay taxes on SS
12:26 - SS tax torpedo
14:27 - Effect on Roth conversions

Create Your Custom Strategy ⬇️

Get Started Here.

Transcript

Speaker 1: 0:00

Welcome back to another episode of Ready for Retirement. On today's episode, we're going to discuss Social Security, how it's taxed and how you can incorporate that into your overall strategic tax planning. This is another episode of Ready for Retirement. I'm your host, james Canole, and I'm here to teach you how to get the most out of life with your money. And now on to the episode. We're going to be addressing a listener question on today's episode, and this question comes from Michael. Michael says the following Hello, I just turned 60 and retired in February of this year.

Speaker 1: 0:30

It'd be great if there was a show that spoke to how social security is currently taxed and the status of bills relating to such tax. What is the basis for the 50% and 85% tax allocation for planning purposes and what are the implications of applying an expected tax? Yes, michael, we certainly can, and social security taxation may seem simple enough at first glance, but there are certainly some nuances to it that are really important to understand, as you're both factoring in your overall income strategy for how are you going to meet your income needs throughout retirement as well as your tax strategy and what that might look like. So, as we jump right in, let's just start with understanding how social security is taxed at the federal rate. When you pay taxes on social security at the federal level we're going to talk about state taxes in a second that income is subject to the same ordinary income tax rates. That say, ira withdrawals are, interest income is, and that's your ordinary income rates the 10%, 12%, 22%, 24%, so on and so forth. What's different is that not all of your social security income is subject to taxes. A chunk of it anywhere from 15 to 100% of it is actually going to be fully excluded from taxation altogether, and this is based upon something called your provisional income.

Speaker 1: 1:58

So let's talk about what provisional income is. It is a relatively straightforward formula and what you do is you start with your adjusted gross income before any social security benefits are included. So IRA withdrawals, pensions, any income from taxable interest, dividends, so on and so forth. You start with that and then you add in any non-taxable interest. So this would be interest from things like municipal bonds. If you look at that interest, you're not actually paying taxes on it at the federal level maybe the state level, depending upon where you live and where the muni bond is from but even though you're not paying taxes on that, you're including it in your provisional income. So you start with your adjusted gross income, add in non-taxable interest and then add in half of your total social security benefit.

Speaker 1: 2:45

Let's look at an example of this. Let's assume that you're single and your income sources are pretty straightforward. The only income that you have is $10,000 that you're pulling out of your traditional IRA and $24,000 per year of social security benefits. So let's assume a benefit of $2,000 per month. Now let's assume, for the sake of simplicity, you have zero in municipal bond interest. You have really zero in any interest, any dividends, anything else, just those two sources. We're going to come back to that in just a second, but keep that in mind. You're single, you have $10,000 of IRA withdrawals in 2000 per month or $24,000 per year of social security income. So total income is $34,000. But what we want to know is how much that social security income will be taxed. Here's how provisional income thresholds work. If you're single and your provisional income not your total income, but your provisional income is under $25,000, then you don't pay any taxes on any of your social security benefits.

Speaker 1: 3:42

Let's look at the example we just went through. So in the example above we're going to start with our adjusted gross income before social security. So in this case that's just the $10,000 of IRA withdrawals, so $10,000. Next we're going to add in any municipal bond interest. Well, there wasn't any, so that's zero. And then next we're going to add in half of this sample individual's social security benefit. So if the total annual social security benefit was $24,000, we're going to take half of that so $12,000, and add that to the provisional income. So what we now get is $10,000 from the IRA plus $12,000, which is the amount of social security included for a total provisional income of $22,000. Well, we look at that and what we can see is $22,000 is less than $25,000. It's very basic math there. $22,000 being less than $25,000 means that zero of this individual's Social Security benefits will be taxed, not even included in the taxable income or the adjusted gross income that taxes are based upon. So for this individual, the only income that they're reporting on is that $10,000 IRA distribution Now for 2024, their standard deduction to fully offset that, and they would be in the 0% tax bracket. And that's because the 10,000 is the only income that they're actually paying taxes on, or that's actually subject to tax brackets, I should say, but the standard deduction fully wipes it out. So, provisional income if your provisional income is under $25,000 and you are single, you don't pay taxes on any of your social security benefit. If your provisional income is between $25,000 and $34,000, you may have to pay income taxes on up to 50% of your benefits. There's a sliding scale here, and if your provisional income is more than $34,000, then up to 85% of your benefits may be taxable, may be included in the income that you're going to pay taxes on.

Speaker 1: 5:33

Let's look at another example. So take that same example we just did, except for, instead of taking $10,000 from an IRA, this individual takes $35,000 from the IRA. So what does that do? Well, first we want to look at his provisional income. $35,000 is the IRA, so what does that do? Well, first we want to look at his provisional income. $35,000 is included in the provisional income because that's coming from the IRA, plus half of his $24,000 annual social security benefit, which is $12,000. So $35,000 plus $12,000, $47,000 is this individual's provisional income, which means 85% of his social security benefit is taxable. It does not mean he's paying 85% tax rate. It means 85% of the $24,000 is included in the amount that gets taxed. So what does that mean? It means that $55,400 are taxable taxed. Now he still gets to take the standard deduction or itemized deduction if he happens to be itemizing against that. But what you see now is this individual is now in the middle to top of the 12% federal income tax bracket. The reason for that is in the first example. When he only took 10,000 from his IRA, his provisional income was kept under a certain threshold, which means none of the social security was included, and he also had a lower amount of IRA income included. Now, by taking $35,000 out of his IRA, not only is that $35,000 more income that's being taxed, but it's also pulling more of the social security benefit into the amount of income that's going to be taxed. So this is an important thing to know. This ties into what's called the social security tax torpedo that we're going to talk about in a little bit, but those are the thresholds that you need to understand With provisional income.

Speaker 1: 7:07

If you are single and your provisional income is under $25,000, just to recap real quick none of your social security benefits are taxed. If your provisional income is between $25,000 and $34,000, up to 50% may be taxed and once it's above $34,000, up to 85% may be taxed. Married, filing jointly. The structure is the exact same in terms of how you look at this, but the thresholds are different For married filing jointly. If you're under $32,000, 0% or zero of your social security benefits are taxable. Between $32,000 and $44,000, you may have income taxes on up to 50% of your benefits. In more than $44,000 of provisional income, up to 85% of your benefits may be taxable. So keep in mind those are provisional income numbers.

Speaker 1: 7:54

For example, someone could have $80,000 in combined social security benefits. That'd be pretty significant social security. But say you have two spouses, both of which had good paying jobs and both of which paid into social security for several years. They both have $80,000 of income combined and that's all their income. Only half of that is included in their provisional income. So it's that $40,000 that then determines how much of the $80,000 total benefit is included in the amount that's going to be taxed. So that's at the federal level, bottom line with the federal level. Two is never more than 85 percent of your social security benefit is going to be included in what gets taxed. So that makes social security very tax efficient, at least compared to other income sources. If you could choose to have one more dollar in social security versus one more dollar and say an IRA distribution, all else being equal and of course all else is not ever equal but all else being equal, the social security dollar is going to go further because less of it is going to be subject to taxes.

Speaker 1: 8:54

Let's now turn our attention to state taxes of social security. The good news is there are 40 states that do not tax social security at all. So most states don't. And even those 10 that do, they're typically taxing it at a lower rate or applying some credit or exemption. So the states that do tax it to some extent Connecticut, kansas, montana, nebraska, new Mexico, rhode Island, vermont, utah they all do tax social security, but there's a lot of exemptions or credits they'll typically provide. So, for example, new Mexico this is as of 2023, but taxes on social security benefits in New Mexico have been phased out for individuals earning less than $100,000 a year and married people filing jointly who earn less than $150,000 per year. I just cherry picked one of those 10 reading right from an article here. But, as you can see, is, if your income in retirement and for the majority of people in retirement, their income is going to be less than those amounts, they might have none of their social security benefit taxed. So, even as I say, 10 states do tax it, that may or may not be the actual case for you and it's going to depend upon your taxable income situation. So take a look at that based upon where you live. But a majority of states are not taxed in social security at all. Now, once you do understand what your provisional income is, you know what your overall tax bracket is.

Speaker 1: 10:11

The next question people have is how do I actually pay taxes on my social security benefit? Well, there's a couple of ways. One is when you're retired, you can make estimated tax payments. I did an episode a couple of weeks back where I talked about how do you actually pay taxes in retirement. It's not like payroll anymore, where they simply withhold taxes for you depending on where your income is coming from. Well, social security is a little bit funky because social security is still subject to the same ordinary income tax brackets the 10 percent, 12 percent, 22 percent, 24 percent, so on and so forth but not more than 85% of your social security benefit is included in your taxable income or is included in your income that gets taxed. That makes it a little bit funky to understand. Well, how much should I actually be withholding?

Speaker 1: 10:54

Social security does have a form that allows you to withhold federal income taxes from your benefit. The withholding mounts are a little bit funky. You can either withhold 7%, 10%, 12% or 22%. Those are your only four options. In some cases those may be too much, in some cases those might not be enough. But really and this goes back to Michael's question even you need to coordinate it with your overall tax situation. If you are going to owe taxes at the end of the year, the IRS does not really care.

Speaker 1: 11:22

Do you withhold those taxes from your social security benefit or from your IRA payment or through estimated payments that you're making along the way? The more important thing is are you making those payments in a timely manner? You could over-withhold from your traditional IRA and withhold nothing from social security, or vice versa. If you know how much you need to withhold in taxes, you could over-withhold from social security and under-withhold on IRA distributions or other income sources. So that doesn't matter so much. What really matters is do you know what your expected tax bill is going to be and do you have a strategy for paying it? But, michael, to your point of asking what does that look like. That could look like a number of different things.

Speaker 1: 12:01

Typically this is not the same for everyone, but typically I'll find that withholding money from IRA payments gives you the most flexibility, simply because most custodians where you hold your money you have more flexibility in terms of how much are you withholding. It's like social security, where you get a handful of limited options 7%, 10%, 12%, 22%. Your tax rate is going to be a blended rate, meaning even if you're in one of those marginal tax brackets, your effective tax rate is really what you want to look at, and sometimes withholding from IRA distributions gives you a bit more control, or a lot more control, as the exact dollar amount that you're withholding for your benefit. And then the final thing that I want to make sure we're talking about, as I alluded to before, is something called the social security tax torpedo. The social security tax torpedo sounds a little bit dramatic and in reality, sometimes it actually is quite dramatic on your tax situation, if you're totally unaware of this, but here's how it works.

Speaker 1: 12:54

So when you are increasing your provisional income through specific thresholds, as we talked about, as your provisional income increases, more of your social security is then pulled into the amount of income that you are paying taxes on. So there's a very specific band depending on whether you're single or married filing jointly, where, let's say, you take one more dollar from your traditional IRA. While doing that let's assume you're in the 12% tax bracket You're going to pay 12% taxes on that dollar, but at the same time, that extra dollar from your IRA is going to increase your provisional income by $1. That provisional income increasing by $1 is going to pull in 85 more cents of Social Security that you previously had but wasn't taxed, and now it will be taxed. So there's a specific range that you need to be aware of and in that range, even though you might be in the 12% federal income tax bracket, your effective tax bracket is actually 22.2%. Where does that come from? Well, you take out one more dollar from your IRA that's taxed at 12%. So there's 12 cents on the dollar. In addition to that, that $1, which increases your provisional income, which pulls in an extra 85 cents of social security into the amount of income that's taxed, that 85 cents of extra income is then also taxed at 12%. So when you take 85% of 12%, which is social security, plus the 12% of the extra dollar from your IRA, you took the total effective tax rate, there is 22.2%.

Speaker 1: 14:27

This is something you do need to be aware of. You're going to still be in the 12% marginal tax bracket, but the social security tax torpedo is hurting you more there than otherwise would have. So this is a big thing, especially for those of you that are doing Roth conversions Roth conversions through a specific bracket. You might think that you're in the 12% federal income tax bracket, but the effective tax rate when you factor in both the tax rate that you're going to pay on that Roth conversion plus the extra social security that's now going to be pulled into your overall taxable income, you have to be very wary of that. Now, that doesn't mean you shouldn't be doing Roth conversions if you're in this income band, but you need to be mindful of it, because you're not comparing Roth conversions at 12% today versus whatever they might be in the future. What you really are comparing is Roth conversions at the 12% marginal bracket but 22.2% effective tax rate on those conversions. Compare that to where you might be in the future. So this gets a little bit more complicated, a little bit more in the weeds. This is where, of course, a good financial planner or tax planner can help with some of this, but that is something that too many people are unaware of when it comes to looking at their Social Security benefits. So, michael, I hope that's helpful. Just a breakdown of how is Social Security taxed, both at the federal level, at the state level, a couple of examples to explain how provisional income works, and then a word of warning on the social security tax torpedo and what to look at there. So I hope this was helpful.

Speaker 1: 15:55

Thank you to all of you who are listening and tuning in. If you have not already done so and you're enjoying the show, please leave a review on Apple Podcasts or subscribe on Apple Podcasts or Spotify if you listen there. If you're watching on YouTube, please make sure that you're subscribing to the channel. We release this podcast every Tuesday on the YouTube channel, and then another video on Saturday mornings as well. So thank you, as always, for listening. Really appreciate you tuning in and I'll see you all next time.

Speaker 1: 16:18

Hey everyone, it's me again. For the disclaimer. Please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Nothing in this podcast should be construed as investment, tax, legal or other financial advice. It is for informational purposes only. Thank you for listening to another episode of the Ready for Retirement podcast. If you want to see how Root Financial can help you implement the techniques I discussed in this podcast, then go to rootfinancialpartnerscom and click start here, where you can schedule a call with one of our advisors. We work with clients all over the country and we love the opportunity to speak with you about your goals and how we might be able to help. And please remember, nothing we discuss in this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions.