It is always a good idea to start your tax planning process toward the end of the year, and if you are a 50-plusser, you will want to start thinking about setting aside money for taxes related to your retirement income.
I asked Dave Freitag how to figure out how much taxes you will have to pay in taxes on your Social Security benefits.
Freitag: If you have started collecting Social Security benefits, you might have noticed that income tax is not automatically withheld from the benefit payments. Since 1983, however, Social Security benefits are reported as income, and income tax is due. The Social Security income tax formula is slightly confusing because it is based on an IRS formula called “combined income.”
The combined income formula used to calculate how much income tax you have to pay on your Social Security benefits has three parts:
- Add any tax-exempt interest income (like interest from municipal bonds) to your adjusted gross income.
- Next, add half of your Social Security income to that answer, and you have your combined income value determining how much of your Social Security income you will report for the year.
- Once you have determined your combined income value, it is subject to a unique formula that calculates how much of your Social Security income will be taxed. For example, if your household combined income is $44,000 or more (for a married couple filing a joint return), up to 85% of your Social Security payments will be reported as income.
fyi50+: Does that mean you have an 85% income tax on your Social Security benefits? That sounds very high.
Freitag: It is easy to get confused about that. If you report 85% of the payment, it will only be taxed at your respective tax bracket. So, if you are in a 20% tax bracket, then 20% of the 85% will determine how much income tax you pay on the benefit.
fyi50+: How does this differ from income taken from a traditional IRA account?
Freitag: Income from an IRA withdrawal is consistently reported at 100%. If you take out a dollar, one dollar will count as income and be taxed at your respective tax bracket. The government provided a tax deduction when the money was paid into the IRA account. The government wants its share of the action when the money is taken out of the traditional IRA.
fyi50+: So that sounds like income from Social Security has a tax advantage over income taken from a traditional IRA.
Freitag: Correct. Even at the highest level, the Social Security dollar has a 15% tax advantage over a dollar taken from the IRA. That is why it pays to have a tax plan in retirement that is tied to the different sources of income you have to support your lifestyle.
fyi50+: What should folks do to prevent the surprise of a big tax bill in retirement?
Freitag: That is where the “voluntary withholding” strategy comes into play. An individual can elect to have income tax voluntarily withheld from their Social Security payment. There are four choices of the amount you can ask to be withheld: 7%, 10%, 12%, and 22%. The voluntary withholding forms can be downloaded from the SSA.gov website, completed, and mailed to a local Social Security office. They will handle the rest.
fyi50+: How do you check how much the government withholds from your payments?
Freitag: This will be reported on the Social Security 1099 form you get at the end of the year. You can also see the withholding amount on your Social Security myAccount.
fyi50+: What suggestions do you have about planning for this tax?
Freitag: It is always a good idea to consult a CPA. However, having some Social Security benefits withheld is generally better, so there is no big tax surprise at the end of the year.
fyi50+: This is valuable information we can all use to make better financial decisions.
