For the past three weeks we have been examining the Social Security nitty-gritty, especially focusing on when you should take benefits and options for married couples to maximize their benefits. Today is our last installment of the Social Security series, and I would like to address another aspect of Social Security benefits that might affect your financial planning strategy: taxation of benefits.
Under what circumstances might your Social Security benefits become subject to taxation? Like most aspects of Social Security, there are several possible answers depending on factors such as your marital status and “Combined Income.” Combined Income is calculated based on the following equation:
CI = Adjusted Gross Income + Nontaxable Interest + ½ Social Security Benefits
If you are filing your tax return as an individual, these figures are based on your individual earnings. If you are filing a joint return, the figures are based on you and your spouse’s combined earnings.
According to the Social Security website, Social Security benefits are tax-free for individuals whose Combined Income is below $25,000 and for married couples whose Combined Income is below $32,000. For individuals whose Combined Income is between $25,000 and $34,000, Social Security benefits are up to 50% taxable. For individuals whose Combined Income exceeds $34,000, benefits are up to 85% taxable. The figures are higher for couples filing jointly: benefits are 50% taxable if the Combined Income is between $32,000 and $44,000 and 85% taxable if the Combined Income exceeds $44,000.
So when might your benefits be taxable, and how can you plan to avoid having your benefits depleted by heavy taxation? Let’s start by ruling some folks out: if in retirement your only source of income is Social Security benefits, chances are you will not have to pay taxes because your Combined Income will be under $25,000. But if you plan to start receiving benefits while you are still working, or if you have a great pension or are receiving a significant amount of interest from investments, your Combined Income could easily exceed $25,000, and you might face taxation of your benefits.
If you are still earning a significant income when you reach Full Retirement Age, you might want to consider delaying receipt of your Social Security benefits. As previously discussed, your monthly benefit will increase the longer you wait to collect on Social Security up to age 70. If you decide to receive benefits at FRA and you are still working, your total benefit may be reduced by taxation. On the other hand, you can maximize your benefit by living off your current earnings for as long as possible and then collecting a larger monthly benefit after partial or full retirement from the work force.
Of course, married couples have even more options because there are more variables in their Combined Income equation. They might choose to collect spousal benefits while delaying full benefits, have one spouse retire earlier than the other, or consider other ways to adjust one or both of their incomes to keep their Combined Income below the taxable mark.
Figuring out how to maximize your Social Security benefits is a complex calculation based on so many different options and variables that many individuals and couples find it overwhelming. Talk to a financial advisor to find out what solution is best for you and your family. If you need help getting started or want to know more about the legal side of Social Security benefits, get in touch with us at Elder Law of East Tennessee. We can help you think about your options and get going in the right direction.