Income Tax Attributable to Social Security Benefits
In Part 1 of this series, we learned that the penalty for flipping the Social Security switch at age 62 instead of at full retirement age (“FRA”) is anywhere from a 20.83% to 30% reduction of benefits otherwise payable beginning at FRA depending upon one’s year of birth.
An example was used in Part 2 whereby an individual born between 1943 and 1954 who was entitled to receive a monthly benefit of $2,000 beginning at age 66 instead received $500, or 25% less per month, or $1,500 as a result of commencement of payments at age 62. The amount of the benefit was reduced by an additional $250 per month to $1,250 as a result of the individual receiving earnings in excess of the current specified annual limit of $14,160.
Up until now, we’ve been looking at the benefit reduction administered by Social Security Administration, or SSA. Depending upon the amount of your Social Security benefits, other income, and tax filing status (e.g., individual, joint, or married filing separate), your already reduced benefit may be further slashed by federal, and potentially state, income taxes. Most states, including California where I live, don’t tax Social Security benefits, however, there are currently 17 states where this isn’t the case. The remainder of this post will address federal income taxation of Social Security benefits.
Taxation of Social Security benefits is dependent on the amount of one’s “combined income” in excess of specified limits that varies depending upon tax filing status. “Combined income” is equal to the sum of the following three components:
Adjusted Gross Income (“AGI”) + Nontaxable Interest + ½ of Social Security Benefits
If your filing status is “individual,” up to 50% of your benefits will be taxable if your “combined income” is between $25,000 and $34,000. The percentage increases up to 85% for “combined income” in excess of $34,000.
If your filing status is “joint,” up to 50% of your benefits will be taxable if your “combined income” is between $32,000 and $44,000. The percentage increases up to 85% for “combined income” in excess of $44,000.
Continuing with our example from Part 2 using employment income of $20,160, let’s also assume Social Security of $15,000 ($1,250 per month x 12 months). Let’s further assume “joint” filing status with the spouse receiving pension income of $20,000 and use of the standard deduction. “Combined income” would be $63,660 (employment income of $20,160 + pension income of $36,000 + ½ of Social Security benefits of $15,000). Since “combined income” is $63,660, 85% of Social Security benefits will be taxable. Federal income tax, assuming no Social Security, would be $3,982. This increases to $5,894 after including the taxable portion of Social Security benefits, resulting in federal income tax of $1,912 attributable to Social Security income. The income tax hit could be greater if our couple happened to live in one of the 17 states that tax Social Security benefits.
After taking into consideration the benefit reductions attributable to commencement of benefits at age 62, receipt of employment income, and income tax attributable to Social Security benefits, the annual Social Security benefit of $24,000 receivable beginning at age 66 is reduced by $10,912, to $13,088 at age 62 per Exhibit 1.
The benefit receivable at age 62 of $13,088 represents a reduction of 45.5%, or receipt of 54.5% of benefits of $24,000 otherwise payable had the individual in our example waited until age 66 to begin receiving Social Security. While the work-related portion of the benefit reduction would end and can potentially be recouped (see Part II of this series) beginning at age 66, and while it’s possible that income tax attributable to Social Security benefits may continue at age 66, additional analysis would need to be done to determine if a four-year annual benefit reduction of approximately $11,000 and a continued lifetime benefit reduction of $6,000 thereafter justifies flipping the Social Security switch at age 62.
Part 4 will discuss how the decision to begin receiving Social Security benefits prior to full retirement age may affect the amount of your spouse’s benefit.