Article Highlights:
- Funding
- Taxation Thresholds and Conditions
- Railroad Retirement
- Married Taxpayers Filing Separate
- Survivor Benefits
- Strategies to Minimize Taxation
- Income Planning
- Tax-Deferred Savings
- Tax-Efficient Investments
- Deductions and Credits
- Tax Withholding on SS Benefits
- Same-Sex Married Couples
- Gambling & Social Security Taxation
- International Aspects and Treaties
Social Security benefits serve as a crucial financial backbone for millions of retirees, disabled individuals, and families of deceased workers in the United States. However, the taxation of these benefits often presents a complex landscape for beneficiaries. This article delves into the intricacies of how Social Security benefits are taxed, the conditions under which these benefits become taxable, and strategies to minimize tax liabilities.
These benefits are part of a social insurance program that provides retirement income, disability income, and survivor benefits. Funded through payroll taxes collected under the Federal Insurance Contributions Act (FICA) and the Self-Employment Contributions Act (SECA), the Social Security Administration administers these benefits. The retirement benefits an individual receives is based on their lifetime earnings in work in which they paid Social Security taxes, modified by other factors, especially the age at which benefits are claimed. Benefits are adjusted annually for inflation.
Taxation Thresholds and Conditions – The taxation of Social Security benefits is contingent upon the beneficiary’s “combined income,” which includes adjusted gross income, nontaxable interest, and half of the Social Security benefits. The Internal Revenue Service (IRS) uses this combined income to determine the portion of benefits subject to taxation.
For individuals, if the combined income falls between $25,000 and $34,000, up to 50% of the benefits may be taxable. Should the combined income exceed $34,000, up to 85% of the benefits could be taxable. For married couples filing jointly, these thresholds are set between $32,000 and $44,000 for up to 50% taxation, and above $44,000 for up to 85% taxation. When the combined income is less than $25,000 ($44,000 for married joint filers), none of the Social Security benefits are taxable, with an exception for some married taxpayers filing separate returns as noted below.
Railroad Retirement – The taxation rules that apply to Social Security benefits also apply to Railroad Retirement benefits. Railroad Retirement benefits are reported on Form RRB-1099 whereas Social Security benefits are reported on Form SSA-1099.
Married Taxpayers Filing Separate – Some married taxpayers for one reason or another may choose not to file jointly and instead each spouse files a return using the status Married Taxpayer Filing Separately. Married individuals filing separately generally face taxation on up to 85% of benefits, regardless of combined income, if they lived with their spouse at any point during the tax year.
Survivor Benefits – Social Security survivor benefits are payments made by the Social Security Administration (SSA) to the family members of a deceased person who earned enough Social Security credits during their lifetime. Eligible family members include widows, widowers, divorced spouses, children, and dependent parents.
These benefits are a crucial financial support for families who have lost a wage earner. However, many beneficiaries are unaware that these benefits may be subject to federal income tax, depending on various factors.
Survivor benefits can be taxable and the amount that is taxable is determined in the same manner as for a retiree as discussed previously based on the beneficiary’s total income and filing status.
Children and Social Security Survivor Benefits – A child’s taxable Social Security benefits are treated as unearned income and subject to the Kiddie Tax rules and thus will generally be taxed at their parent’s top marginal tax rate. The Kiddie Tax is designed to prevent parents from shifting large amounts of investment income to their children to take advantage of the child’s lower tax rate.
- If the child only receives Social Security benefits and has no other income, the benefits are typically not taxable, and the child may not need to file a tax return.
- If the child has other income, the taxability of Social Security benefits depends on their “combined income.” Combined income includes the child’s adjusted gross income (AGI), nontaxable interest, and one-half of the Social Security benefits. Basically, the same way a retiree’s benefits are taxed.
Strategies to Minimize Taxation – Beneficiaries can adopt several strategies to minimize the taxation of their Social Security benefits.
- Income Planning – Adjusting the timing and sources of income can help keep combined income below the taxable thresholds. For example, delaying withdrawals from retirement accounts or strategically timing the sale of investments can reduce AGI. If required to take distributions from a traditional IRA or 401(k) account, only take the minimum amount required if possible.
- Tax-Deferred Savings – Contributing to tax-deferred savings accounts, such as traditional IRAs or 401(k)s, can lower AGI, potentially reducing the taxable portion of Social Security benefits. Of course, this suggestion only applies to those who have earned income (wages, self-employment income).
- Tax-Efficient Investments – Investing in tax-efficient vehicles, such as Roth IRAs or growth stocks that aren’t currently paying dividends, can generate income that doesn’t count toward combined income, thus reducing the taxability of Social Security benefits.
- Deductions and Credits – Taking advantage of all eligible tax deductions can lower AGI, which in turn can reduce the taxable portion of Social Security benefits.
Other Issues
- Tax Withholding on SS Benefits – Taxpayers can elect to have federal income tax withheld from their Social Security benefits and/or the SSEB portion of Tier 1 Railroad Retirement benefits. Use Form W–4V to choose one of the following withholding rates: 7%, 10%, 12%, or 22% of the total benefit payment (flat dollar amounts aren’t permitted). Once completed, the W-4V form can either be mailed or faxed to the Social Security Administration.
- Same-Sex Married Couples – The Supreme Court determined that same-sex couples have a constitutional right to marry in all states. As a result, the Social Security Administration says that same-sex couples will be recognized as married for purposes of determining entitlement of Social Security benefits. Therefore, their Social Security benefits are taxed the same way as for married taxpayers.
- Gambling & Social Security Taxation – For tax purposes gambling winnings are added to a taxpayer’s income while gambling losses are deducted as an itemized deduction. Thus, even if the gambling resulted in a net loss, the full amount of the gambling winnings is added to the combined income which can make more of the Social Security benefits be taxable or cause some of the benefits to be taxable at the higher 85% rate.
Example: Suppose the combined income, without considering gambling income, for a married couple filing a joint return is $30,000. That is below the combined income Social Security taxable income threshold of $32,000. Thus, none of the couple’s Social Security benefits are taxable. However, suppose the couple are recreational gamblers and for the year had winnings of $20,000 and losses of $21,000 for a net gambling loss of $1,000. Because the gains and losses are not netted, the $20,000 of gambling winnings is added to the combined income, bringing it to $50,000, which makes nearly all the Social Security benefits taxable.
To make matters even worse, if a taxpayer is covered by Medicare, the Medicare premiums are based on the taxpayer’s income two years prior, so the gambling winnings might very well also cause an increase in future Medicare premiums. If married taxpayers are both covered by Medicare, the increase would apply to each spouse.
- Lump-Sum Payments – Some SS beneficiaries may receive a lump-sum payment that includes benefits for previous years. Special rules apply for reporting and taxing these payments, allowing beneficiaries to potentially reduce their tax liability.
- State Taxes – While this article focuses on federal taxation, it’s important to note that some states also tax some or all Social Security benefits, which as of 2023 included Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, Rhode Island, Utah, and Vermont.
- International Aspects and Treaties – The taxation of Social Security benefits also has international dimensions. The U.S. has entered tax treaties with several countries, which can affect how benefits are taxed for residents and nationals of those countries. For instance, benefits paid to individuals who are both residents and nationals of treaty countries may be exempt from U.S. tax.
The taxation of Social Security benefits has evolved since its inception nearly 90 years ago, and future legislative changes could further impact how these benefits are taxed. Beneficiaries and financial planners must stay informed about these changes to effectively manage tax implications. This article includes issues in effect as of April 1, 2024.
If you have questions related to taxation of Social Security benefits, please contact this office.
If you have any questions, please contact our office at (503) 224-5321. Isler Northwest LLC is a firm of business advisors and CPAs in Portland, Oregon. Our service goal at Isler Northwest is to earn our clients’ trust as their primary business and financial advisor.
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