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Social Security & paying taxes in retirement

Income taxes on Social Security benefits? It's true. Careful planning can take away the sting if you have to pay.

POINTS TO KNOW

  • Retirees with moderate or higher incomes likely will pay federal taxes on some portion of their benefits.
  • Thirteen states also impose a state income tax on Social Security benefits.
  • Carefully consider the possibility of taxation of your Social Security benefits when designing a strategy for retirement income.

Will you owe taxes on your Social Security benefits?

As with most questions about taxes, the answer is "it depends."

About 40% of people who get benefits pay income taxes on them, according to the Social Security Administration (SSA). That's because their income in retirement exceeds limits set by tax rules and regulations.

Generally, if Social Security is your only retirement income, you won't have to pay taxes on it. But if you have at least moderate income, you'll most likely owe the government some money.

The good news is that while up to 85% of your benefits may be taxed at ordinary income rates, it's never 100%. That's considered tax-efficient compared with other retirement plans whose distributions may be fully taxable. In addition to the federal tax bite, 13 states also tax Social Security benefits using either the federal provisional income formula or their own.

States that tax your Social Security income

States that tax Social Security benefits: Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont, West Virginia

What's the provisional income formula?

Whether you'll owe taxes on your benefits is based on a provisional income (PI) formula: your modified adjusted gross income (AGI) plus tax-exempt bond interest plus half of your Social Security benefits.

Social Security income limits


FILING STATUS

Single; head of household; qualifying widow/widower; married, filing separately (spouses lived apart for all of the tax year)

PROVISIONAL INCOME THRESHOLD

$0 to $25,000

>$25,000

>$34,000

% OF TAXABLE BENEFITS

0%

Up to 50%

Up to 85%


FILING STATUS

Married, filing jointly

PROVISIONAL INCOME THRESHOLD

$0 to $32,000

>$32,000

>$44,000

% OF TAXABLE BENEFITS

0%

Up to 50%

Up to 85%


FILING STATUS

Married, filing separately (spouses lived together at any time during the year)

PROVISIONAL INCOME THRESHOLD

$0

% OF TAXABLE BENEFITS

Up to 85%

Source: Internal Revenue Service Publication 915, Social Security and Equivalent Railroad Retirement Benefits External site.

How it works

The amount of Social Security income that's taxable is the smallest of the following 3 calculations.

  1. 85% of Social Security benefits.
  2. 50% of Social Security benefits + 85% of excess PI over $34,000 (for single recipients) or $44,000 (for married recipients, filing jointly).
  3. 50% of excess PI over $25,000 (for single recipients) or $32,000 (for married recipients, filing jointly) + 35% of excess PI over $34,000 (for single recipients) or $44,000 (for married recipients, filing jointly).

At the end of the year, Social Security will send you a statement of your benefits for you to use when completing your federal income tax return.

Did you know?

You can ask the government to withhold taxes from your benefit payment, although you're not required to do so. If you'll owe taxes, withholding has 2 advantages: You won't have to pay a lump sum at tax time, and you'll avoid a potential penalty for underpaying your taxes.

You could also satisfy your tax bill by having taxes withheld from other income sources, such as IRAs, pensions, or annuities, or by making quarterly payments to the Internal Revenue Service (IRS). You may want to consult a tax advisor.

Create a tax-efficient Social Security strategy

Your decision about when to claim Social Security should include tax efficiency as a factor—that is, how much taxable income you retain after paying applicable income taxes.

Generally, your Social Security income will have a more favorable tax treatment than retirement income from accounts such as traditional IRAs or 401(k)s.

That's because you'll never pay taxes on 100% of your benefits, whereas you'll pay your ordinary tax rate on income from other retirement accounts unless you've selected a Roth IRA.

Taking tax efficiency into account can help you decide whether it's advantageous to delay claiming Social Security benefits and determine the best way to tap into your sources of income to meet your cash flow needs in retirement.

Managing how much of your income comes from Social Security versus other sources can make a big difference in your ability to support your long-term retirement plan.

Consider these strategies

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Control your taxes now & later

The longer you wait to claim Social Security benefits, the better chance you'll have to boost the overall tax efficiency of your retirement income plan. Here's how.

Drawing down traditional tax-deferred assets before collecting Social Security can enable you to control both your current and future taxes.

The amount you withdraw from a traditional IRA, for example, lowers your account balance, which may reduce your future required minimum distributions (RMDs).

Since your RMD is considered ordinary income, having smaller distributions while you're collecting benefits may reduce the taxes on your benefits—or keep you from paying taxes altogether.

In addition, managing your retirement income in this way can also help you qualify to pay lower Medicare parts B and D premiums, which are income-based.

See how one couple maximized their after-tax retirement income

Leave a tax-efficient legacy

If you want to create a financial legacy for your heirs, plan your retirement income strategy to leave them tax-efficient dollars. Here's an order to follow:

  • Assets held in Roth accounts are the most tax-efficient dollars to inherit since any distribution an heir receives will be income tax-free.
  • Assets in taxable accounts are the next most tax-efficient to inherit because the cost basis of the investments will be stepped up for the beneficiary, alleviating capital gains taxes.
  • Assets in tax-deferred accounts, such as traditional IRAs, are less tax-efficient to inherit because any withdrawal a beneficiary takes will be taxed at his or her ordinary income tax rate.

A Vanguard advisor can help

If you're struggling with making your best Social Security decision, we can help. You'll also get a custom financial plan, ongoing portfolio management, investment coaching, and real-time goal tracking—all at a low cost.

Your Social Security guide


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REFERENCE CONTENT

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State taxation of Social Security benefits

Most states don't tax Social Security benefits. But the ones that do either follow the same federal provisional income (PI) rules or have special rules and income thresholds to determine what's taxable.

These 4 states use the federal PI formula: Minnesota, North Dakota, Vermont, and West Virginia. The taxable portion of Social Security for these states is the same as the federal amount.

Nine states have special rules and income thresholds. Most use the federal modified adjusted gross income formula rather than the federal PI formula for taxing Social Security income.

These states are: Colorado, Connecticut, Kansas, Missouri, Montana, Nebraska, New Mexico, Rhode Island, and Utah.

If you live in a state that counts Social Security benefits as taxable income, you should consult your state tax department for details and a qualified tax advisor.

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Provisional income

The level of income used to determine whether someone is liable for income tax on his or her Social Security benefits and how much is subject to tax.

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Adjusted gross income

The amount on which someone pays income tax. It's calculated by subtracting authorized deductions from gross income.

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Individual retirement account (IRA)

A type of account created by the IRS that offers tax benefits when you use it to save for retirement.

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Pension plan

An arrangement under which an employer—and sometimes the employee—makes payments toward retirement, disability, or death benefits for employees who meet certain criteria. Types of pension plans include defined benefit plans, defined contribution plans, employee stock ownership plans, money purchase plans, profit-sharing plans, stock bonus plans, thrift plans, and target benefit plans.

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Annuity

A financial product typically used by investors to save tax-deferred for retirement or to generate regular income payments in retirement.

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401(k) plan

A type of employer-sponsored retirement plan that allows employees to contribute pre-tax dollars by deferring salary. Many plans offer a variety of investment options, and employers often match a percentage of employee contributions.

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Ordinary tax rate

Also known as the marginal tax rate, the income tax rate at which the last dollar of an individual's income is taxed. Under federal law, the individual pays a lower tax rate on his or her first dollar of income than on his or her last dollar. The marginal rate—the highest rate at which the individual's income is taxed—is used to calculate taxes due on investment income.

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Roth IRA

A type of IRA that allows you to make after-tax contributions (so you don't get an immediate tax deduction) and then withdraw money in retirement tax-free as long as you meet the requirements.

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Tax deferral

Delaying the payment of income taxes on earnings generated in an investment account. For example, if you have a traditional IRA, you don't pay income taxes on the interest, dividends, or capital gains accumulating in the account until you begin making withdrawals.

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Required minimum distribution (RMD)

Under federal tax law, most owners of IRAs (except Roth IRAs) and employer-sponsored retirement plan accounts must withdraw part of their tax-deferred savings each year, starting at age 70½ (or after inheriting an account). If you withdraw less than the required minimum distribution, you may owe a 50% penalty tax on the difference.

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Medicare parts B and D

Medicare Part B covers doctors' office visits, lab work, X-rays, some medical supplies, and preventive services. Medicare Part D offers prescription drug coverage.

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One married couple's tax-efficient Social Security strategy

The following scenarios illustrate how taking Social Security benefits early versus delaying until age 70 affects the federal taxes of this married couple, who are both age 62.

Scenario 1: Taking benefits at age 62

Michael and Patricia anticipate a pre-tax retirement income of $75,000, consisting of $24,000 from their Social Security benefits and $51,000 in taxable distributions from their IRAs.

Based on their earnings history at age 62, 85% of their Social Security benefits would be taxable.

Assuming no other income and using the standard deduction, Michael and Patricia would owe $5,307 in federal taxes. Their after-tax income is $69,693.

Scenario 2: Delaying benefits until age 70

In the years between their retirement and age 70, Michael and Patricia would need to take additional taxable distributions from their IRAs.

But at age 70, they'd receive $42,240 in Social Security benefits, meaning they'd need only $32,760 in IRA withdrawals, including required minimum distributions (RMDs).

Using the same assumptions (no additional income and the standard deduction), only 34% of the couple's Social Security benefits would be taxable, and their federal taxes would total $2,086. Their after-tax income would be $72,914.

In this scenario, their total taxes would be slightly higher in the years before they claim Social Security benefits, but lower taxes after age 70 would offset the initial tax cost in less than 2 years.

Social Security claiming strategies at a glance

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Cost basis

The original cost of an investment (adjusted for commissions or capital distributions). For tax purposes, the cost basis is subtracted from the investment's value at the time of sale, minus fees and commissions, to determine any capital gain or loss.

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Stepped-up cost basis

The cost basis of the account that you're inheriting refers to how much the account owner paid for the investments in the account. The stepped-up cost basis is the cost basis adjusted to the fair market value available when you inherit the assets.

You may benefit from a stepped-up cost basis if the fair market value of the investments on the day the account owner died is more than the account owner paid for the investments. Because of the step-up, you may be able to avoid or minimize capital gains taxes if you sell the investments.

Consult with a tax advisor if you have questions about the IRS rules regarding stepped-up cost basis.

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Capital gain/loss

The difference between the sale price of an asset—such as a mutual fund, stock, or bond—and the original cost of the asset.

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Full retirement age (FRA)

The age at which you're eligible for your full monthly benefits, also known as the primary insurance amount (PIA). The Social Security Administration sometimes refers to full retirement age as "normal retirement age" (NRA).

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Beneficiary

A person or organization designated to receive the proceeds of an investment account (or an insurance policy, a pension, or an annuity contract) after the owner's death.