“Wait, what?” Yes, your Social Security might be taxed

Regular readers know that I’ve written often about the ways that retirement income is taxed. But reactions I’ve heard to a recent New York Times column on retirement by contributor Brian J. O’Connor served as a reminder that one retirement tax continues to surprise and confuse many people. That’s the fact that Social Security benefits are taxed in some situations - and the taxation formula.

This email note about the Times story, sent by a professional colleague, sums it up pretty well:

“Wait, what?”

Roughly half of Social Security beneficiaries pay federal income taxes on a portion of their benefits. The formula that determines taxation affects retirees with relatively higher incomes - typically beneficiaries who are still working and/or receiving a good deal of income from pensions or other retirement saving accounts. But the proportion of people who owe taxes is rising, for reasons I’ll explain below.

The confusing formula

The formula that determines whether you owe taxes on your benefits can be confusing. Taxation is triggered when certain types of income exceed a threshold. The income formula used to determine this is called “combined income” (also sometimes referred to as “provisional income”). It’s the sum of your adjusted gross income, nontaxable interest and half of your Social Security benefits.

If your combined income is equal to or below $25,000 (for single filers) or $32,000 (for married filers), no tax is owed on your benefits.

The next tier of income runs from $25,000 to $34,000 for single filers, and $32,000 to $44,000 for married couples filing jointly. They pay federal income taxes on up to 50 percent of their benefits. Beneficiaries with income above those levels pay taxes on up to 85 percent of benefits.

Benefits were first taxed in 1984 as part of a reform package signed into law the previous year aimed at stabilizing the program’s finances — the revenue is credited to the Social Security and Medicare trust funds.

Strategies and planning

The Times story serves as an important reminder that taxation of Social Security benefits should be on your horizon for planning purposes. Most important, higher-income people should be aware that some portion of projected benefits will go back to the government. And, you should decide how you want to pay the tax. You can elect to have Social Security withhold taxes on your benefits, and do a true-up when you file your tax return. Or, you can pay estimated quarterly taxes.

Also, check to see whether your state exempts Social Security income. Most do.

Careful planning before retirement can help minimize or even avoid some of the knock-on effects that taxes on Social Security and Medicare surcharges can create. I describe some of those strategies in a story I wrote last year for the Times on taxation of retirement income. That story takes a wider view of the topic, also considering taxation of pension income and Medicare’s high-income premium surcharges.

What I’m reading

More Americans own stocks than ever before . . . New tests promise to reveal your biological age . . . Seven keys to greater longevity . . . One in five Americans over age 65 are working, nearly double the share 35 years ago.