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Adding Insult to Injury—Taxing Social Security

MP900384841It’s a great year–you’ve finally retired or you are retiring really soon and you’re excited to start your new life. But wait… did you just hear that your Social Security benefit may be taxed?

Taxes are a good reason to take a second and third look at your retirement income plan, even if you’ve already retired and are working part time or have started taking distributions from your retirement accounts. There’s a lot of useful information in this article from Vanguard, “Wait . . . I'll owe taxes on Social Security income?” You’ll need to know whether or not your Social Security income is going to be taxable, before you can make final financial decisions. The deciding factor is known as the provisional income formula, and here’s how the numbers are calculated:

Provisional income (PI) = adjusted gross income (AGI) + tax-exempt bond interest + 50% of your Social Security benefits.

If your PI for the year is above these thresholds, some of your benefits may be taxable. The amount of Social Security income that's taxable is the least of the following three calculations:

  1. 85% of Social Security benefits.
  2. 50% of Social Security benefits + 85% of PI over $34,000 (single) or $44,000 (married, filing jointly.
  3. 50% of PI over $25,000 (single) or $32,000 (married, filing jointly) + 35% of PI over $34,000 (single) or $44,000 (married, filing jointly).

Many states don't tax Social Security benefits, but those that do either follow the same federal PI rules, or they have special rules and income thresholds to determine what's taxable. These four states use the federal PI formula: Minnesota, North Dakota, Vermont, and West Virginia. The taxable portion of Social Security for these states is the same as the federal amount. Nine states have special rules and income thresholds. They are Colorado, Connecticut, Kansas, Missouri, Montana, Nebraska, New Mexico, Rhode Island, and Utah. Most use the federal AGI.

Remember that your Social Security benefit increases the longer you wait to begin taking it, up to age 70. For some folks, especially those who rely on Social Security more than investment income, delaying benefits could help ease their tax burden. However, for those at higher income levels—where up to 85% of Social Security is taxed—delaying benefits may not affect the taxability of their Social Security benefits. However, it is an element in tax planning, when coordinated with other retirement resources.

For many people, taxes are a big factor in deciding where to live after they retire, whether or not to work during their retirement and when to start taking Social Security benefits. Make sure to include taxes when you start mapping out your retirement strategy. When you start taking your Social Security benefit depends on many factors: your overall health, the size of your retirement accounts, your general tax liabilities and whether or not one of your goals is to leave an inheritance to your heirs. Speaking with an estate planning attorney with extensive experience in tax planning can help you make informed strategic decisions.

Reference: Vanguard (November 30, 2016) “Wait . . . I'll owe taxes on Social Security income?”

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