Social Security Overview
The Social Security Act was signed by President Roosevelt in 1935 and since then, everyone who earns an income contributes to Social Security. In 2020, the Social Security taxes were 6.2%. However, for 2021 any amount above $142,800 would only have contributions to Medicare, not to Social Security. It is important to note that this amount changes every year.
There is a correlation between the amount you contribute to Social Security and your amount of benefits. The amount of benefits you receive, however, will not be equal to the amount you contributed over your career. In fact, most people receive way more in benefits than they contributed in taxes.
Instead, Social Security will adjust your lifetime earnings to account for wage changes. Then, Social Security will calculate your monthly earnings during the 35 years where the income was the highest. This income will be used to determine your benefits.
If you didn’t work at least 35 years, then non-working years will be counted as zeroes in the calculations. You can continue to work in order to reduce the amount of years counted as zero. This will increase your benefits.
Social Security as Sole Income
The only situation that will always exclude you from filing a tax return is when your sole income source is Social Security. In this situation, your benefits are not taxable. When Social Security benefits are your only source of income, they do not count towards your gross income. Therefore, your gross income is zero and you don’t have to file a tax return.
To determine whether some of your Social Security benefits are taxable, you will need to use any compensation including tips. You will also need to use self-employment earnings, investment earnings, and taxable distributions such as those from a traditional IRA or a 401(k). You will not, however, use non-taxable distributions from Roth IRAs.
You may choose to continue work even after you begin to receive benefits. However, there is an annual limit to your benefits. The annual limit for those under full retirement age for the entire year in 2021 was $18,960 and your Social Security benefits will be reduced $1 for every $2 you earn above this limit amount. In the year in which you reach full retirement age, the Social Security Administration will deduct $1 for every $3 you earn above a different amount up to the month you reach full retirement age. In 2021, the full retirement age amount was $50,520.
But, after you reach full retirement age, and counting the month you do, your benefits will not be reduced regardless of your income.
Another consideration relates to municipal bond interest. Even though this interest is not taxable, it will be used to determine whether or not your benefits are taxable. Even if you have to pay taxes on your benefits, the municipal bond interest will remain tax-exempt.
You may not want to pay taxes on your Social Security benefits, but, as Social Security consultant Tom Clark put it, “When someone asks me if they will have to pay income tax on their Social Security benefits, I tell them ‘I hope so’ because that means they have planned well for retirement and have good income in retirement. Also, most people don’t know where the money goes. Income tax paid on Social Security benefits does not go into the general fund like your other income taxes -- it goes back into the Social Security and Medicare trust funds.”
How Benefit Tax is Calculated
First, it is important to remember that everyone who receives Social Security benefits will receive a SSA-1099 that shows the total amount of benefits you received the previous year. This is how you can see the amount of benefits you need to report on your tax return.
To determine if any of your Social Security benefits are taxable, you need to add half of your Social Security benefits to all of your other income sources. If the sum is less than $25,000 for an individual or $32,000 for a couple, then you will not owe any taxes on your Social Security benefits. Remember, though, that you may still have to pay taxes on your additional income, just not on your benefits.
You can also complete the calculation on Notice 703 on IRS.gov to see if your amount exceeds the threshold amounts of $25,00 or $32,000.
If the amount of the calculation exceeds the threshold amounts, then you will owe some taxes on your benefits. The amount of benefits that is taxable depends on how much more than the threshold amounts your income amounts to. The taxable amount is on a sliding scale so each situation is unique.
If your threshold income, additional income plus half of your benefits, exceeds $34,000 for an individual or $44,000 for a couple, 85% of your taxes will be considered taxable. However, you don’t pay an 85% tax rate because you will pay the percentage according to the tax bracket you are in. Also, no matter how far above $34,000 or $44,000, you will never pay taxes on more than 85% of your benefits. Therefore, 15% of your benefits will always be tax free.
For additional information about the taxable amount of benefits and how to report them, see the Publication 915 published by the IRS.
Spousal benefits are available to people who are not eligible for their own Social Security benefits, but apply for benefits based on their spouse’s record. Spousal benefits can be up to 50% of the other person’s benefits. The rules and threshold amounts are the same for spousal benefits as they are for other recipients.
Survivor benefits for children are taxable, but rarely does a child make enough additional income to qualify. Additionally, the guardian receiving benefits on behalf of the survivor does not have to report them.
Disability benefits are taxable based on the same threshold amounts as retiree benefits.
Supplemental Security Income, or SSI, is a needs based program designed to help the aged, blind, and disabled who have little or no income. This program provides money for basic needs such as food, shelter, or clothes. SSI benefits are always tax-exempt.
Currently there are 13 states that tax Social Security benefits in some situations. The states that can tax your benefits are Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont, and West Virginia. If you live in one of these states, you need to look up their current benefit tax laws and rules.
Reducing Taxes on Benefits
There are a few strategies that can limit taxes on your Social Security benefits that involve using a Roth IRA or managing withdrawals from your tax deferred accounts. However, it is always important to check with your financial advisor before you use these strategies because every situation is different and there could be additional consequences. Your financial advisor may have other suggestions.