How much of your Social Security Benefit is actually taxable in retirement?

Posted by
January 19, 2023

As someone who knows a lot about financial planning in general, and how retirement income is taxed in particular, this past year I discovered there was one area of the tax law that I was not knowledgeable of all the details. That is, how much of your social security benefit will be taxed. I am sure this is an area that many retired people are knowledgeable in, but, after talking to many retired friends this past year, there are many more who are not familiar. This is especially true of people who, whether retired or not, have not yet started collecting social security benefits.

I discovered my ignorance about social security taxation this past year when trying to do an estimate of our 2022 tax liability. Our tax returns are very simple, but this was the first year we collected any social security benefits as my wife became eligible in 2022. So this was a new income source for us. What I discovered was that social security taxation is not as straight forward as I originally thought. Everyone knows (or should know) about the income brackets that determine how much of your social security benefit is subject to taxation.

For single filers, if your total Provisional Income (PI) is below $25,000, then none of your benefits are taxable. If your total PI is between $25,000 and $34,000 then 50% of your social security benefits are  taxable. If your PI is over $34,000, then 85% of your social security benefits are taxable. For married couples, the corresponding brackets are, less than $32,000, between $32,000 and $44,000, and over $44,000. (NOTE: PI is defined as all your ‘other’ taxable income plus 50% of your social security benefit).

Not having to worry about social security income for years, I was under the impression that these brackets meant that once your total PI retirement income was over $44,000 (for a married couple) that 85% of your social security income would be subject to taxation, and no need to bother worrying about it anymore. In other words, I thought it worked like a one-time drop off a cliff. But that is not how the social security taxation formula works. The taxable amount can increase in a more gradual manner in some situations. It depends on how much of your total income is from social security and how much is ‘other’ taxable retirement income.

The retirees most impacted by this gradual level of social security taxation are the ones in the middle income range….about $50k to $100k….where social security makes up anywhere from 30% to 70% of your total income. This is a large segment of the US retiree population. Rather than discuss all the possibilities and nuances, let me provide a simple example with 2 different scenarios to show what I mean by my statement above where I said ‘it depends’ on how much of your income is from social security versus other income sources.

Let’s assume a married couple both take social security early at age 62 and have combined social security income of $34,000 per year (accepting the 30% reduction from age 67). Their other income is from a $15,000 pension and the rest is $25,000 of taxable portfolio income totaling $40,000. In this example, their total retirement income would be $74,000. Their social security PI would be $57,000 ($40,000 + $17,000). Therefore their social security benefit subject to taxation would be $17,050 (about 50% of their total benefits). Assuming they only take the standard deduction when filing taxes their 2022 federal income taxes would be $3327.

I am now going to change this same married couple’s retirement income sources by having them both delay claiming social security until age 70. By delaying social security start date until age 70, they have increased their total benefit to $60,000 per year (we are not including inflation adjustments in this example). But in order to live from age 62 to 70, this couple had to spend down some of their financial assets. Specifically, $272,000 (8 years x $34k). Assuming a 3.5% Safe Withdrawal rate, that would reduce this couple’s non-social security income from $40,000 per year at age 62 to about $30,000 at age 70. So their ‘other’ income at age 70 would be reduced by about $10,000 which means they would have about $90,000 total income ($60k + $30k) when starting their social security benefits. Importantly, their PI is $60,000 ($30k + $30k). In this second scenario, not only is their total income higher, but only $19,600 of their $60,000 social security benefits would be taxable. This is only 33% of their benefits as opposed to 50% in the first scenario. Additionally, their total taxes for this scenario (assuming same rates and brackets) is only $2433 as opposed to $3327 in the first scenario.

Here is a link to an online calculator to determine how much of your social security benefits are taxable.

https://www.covisum.com/resources/taxable-social-security-calculator

After going through this exercise, there are a couple things that become apparent about how this social security taxation formula can affect your financial planning. I believe it provides another reason why waiting to claim social security benefits until age 70 is financially advantageous. These reasons are:

Reason #3 above is particularly important if you expect to have fairly large Required Minimum Distributions (RMDs) when they must begin (currently at age 73). A strategy that I have been using (and many financial planners recommend), is to wait to collect social security at age 70 to receive the highest benefit possible. Each year, between age 62 and age 69, do a small Roth IRA conversion. The amount I convert does not jump me into a higher tax bracket. I pay the small tax each year. What has this done for me? It has reduced the size of our taxable (i.e., Traditional) IRAs subject to RMDs later. The converted funds now sit in our Roth IRAs. And in case you are wondering….NO…, tax-free Roth IRA distributions are not included in the PI formula to determine how much of your social security benefits are taxable.

Frankly, even if you need the money in your Traditional IRA before age 70 for living, I think it still makes sense to draw funds from your Traditional IRAs, pay the tax, and spend it, in order to delay your social security benefit to allow it to get larger and get more of it tax free at age 70.

In our case, we are using the 10 year period before I turn 70 to convert the entirety of both me and my wife’s taxable IRAs. The only thing that will remain in our taxable IRAs will be a couple of delayed income annuities that we will start drawing on when we each hit the starting age for RMDs at age 73.

There are a few simple rules that govern Roth IRA conversions, and given that this is a taxable event, you should talk to your financial advisor about whether this strategy makes sense for your situation and the proper approach.

Financial Planning Topics, Posts relevant to people Age 50 to 70, Retirement Planning Topics,

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