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 provide a critical financial foundation for millions of retirees, handicapped people, and the relatives of dead workers in the United States. However, the taxation of these benefits frequently creates a confusing picture for recipients. This essay dives into the complexities of how Social Security benefits are taxed, the circumstances under which they become taxable, and options for reducing tax responsibilities.
These benefits are part of a social insurance scheme that includes retirement, disability, and survivor benefits. The Social Security Administration administers these benefits, which are funded by payroll taxes collected under the Federal Insurance Contributions Act (FICA) and the Self-Employment Contributions Act (SECA). The retirement benefits an individual receives are dependent on their lifetime earnings from labor for which they paid Social Security taxes, as adjusted by other criteria, particularly the age at which benefits are claimed. Benefits are modified annually for inflation.
Taxation Thresholds and Conditions - The taxation of Social Security payments is determined by the beneficiary's "combined income," which comprises adjusted gross income, nontaxable interest, and half of their Social Security benefits. The Internal Revenue Service (IRS) utilizes this combined income to calculate the share of benefits that are taxable.
Individuals with combined incomes of $25,000 to $34,000 may be subject to taxation on up to 50% of their benefits. If the total income exceeds $34,000, up to 85% of the benefits may be taxed. For married couples filing jointly, the thresholds are set at $32,000 to $44,000 for up to 50% taxes and above $44,000 for up to 85% taxation. When the total income is less than $25,000 ($44,000 for married joint filers), no Social Security payments are taxable, with the exception of some married taxpayers who file separate returns, as explained below.
Railroad Retirement - Railroad Retirement payouts are subject to the same taxation laws as Social Security benefits. Railroad retirement payments are reported on Form RRB-1099, whereas Social Security benefits are recorded on Form SSA-1099.
Married Taxpayers Filing Separate - For various reasons, some married taxpayers may choose not to file jointly and instead file a return as Married Taxpayer Filing Separately. Married persons filing separately are normally taxed on up to 85% of their benefits, regardless of joint income, if they lived with their spouse at any time during the tax year.
Survivor Benefits - Social Security survivor benefits are payments paid by the Social Security Administration (SSA) to the family members of a dead individual who earned enough Social Security credits throughout their lifetime. Widows, widowers, divorced spouses, children, and dependent parents are all considered eligible family members.
These benefits provide vital financial help to families who have lost a wage earner. However, many beneficiaries are unaware that these benefits may be liable to federal income tax, depending on a variety of criteria.
Survivor benefits may be taxable, and the amount is decided in the same way as for retirees, based on the beneficiary's total income and filing status.
Children and Social Security Survivor payments- A child's taxable Social Security payments are considered unearned income and are subject to the Kiddie Tax regulations, thus they are often taxed at their parent's top marginal tax rate. The Kiddie Tax is aimed to dissuade parents from moving significant sums of investment income to their children to take benefit 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 tax ability 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 to keep total income below the taxable levels. Delaying withdrawals from retirement funds, for example, or carefully timing the sale of investments can help to lower AGI. If you are forced to take withdrawals from a conventional IRA or 401(k), take the least amount feasible.
- Tax-Deferred Savings - Contributing to tax-deferred savings accounts, such as conventional IRAs or 401(k)s, can reduce AGI and potentially cut the taxable component of Social Security income. Of course, this proposal is only applicable to individuals with earned income.
- Tax-Efficient Investments - Investing in tax-efficient vehicles, such as Roth IRAs or growth stocks that are not now generating dividends, can create income that is not counted as combined income, decreasing the taxability of Social Security payments.
- Deductions and Credits - Taking use of all possible tax deductions can reduce AGI, hence lowering the taxable component of Social Security income.
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 FormW-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 ruled that same-sex couples had a constitutional right to marry in all states. As a result, the Social Security Administration states that same-sex couples will be treated as married for the purpose of assessing eligibility for Social Security payments. As a result, their Social Security payments are taxed in the same way as married taxpayers.
- Gambling and Social Security Taxation – Gambling earnings are taxed as income, but gambling losses are deductible as an itemized deduction. Thus, even if the gambling resulted in a net loss, the whole amount of the gambling gains is included to the combined income, which can make more of the Social Security payments taxable or cause part of the benefits to be taxable.
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 worse, if a taxpayer is covered by Medicare, the Medicare premiums are calculated based on the taxpayer's income two years earlier, thus gambling wins may result in a rise in future Medicare rates. If married taxpayers are both Medicare beneficiaries, the increase would apply to both spouses.
- Lump-Sum Payments - Some SS members may get a lump-sum payment that includes payments from past years. Special restrictions apply to reporting and taxing these contributions, potentially reducing beneficiaries' tax liability.
- State Taxes - While the focus of this article is on federal taxes, it is essential to note that several states, including Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, Rhode Island, Utah, and Vermont, tax part or all Social Security payments as of 2023.
- International Aspects and Treaties -The taxation of Social Security benefits also has international implications. The United States has tax treaties with various nations, which can alter how benefits are taxed for their citizens and nationalities. For example, benefits granted to persons who are both residents and citizens of treaty nations may be excluded from US taxation.
Social Security benefits have been taxed in various ways since its founding over 90 years ago, and future legislative changes may have an even greater influence on how these benefits are taxed. Beneficiaries and financial advisers must remain updated about these developments in order to successfully manage tax consequences. This article addresses concerns in effect as of April 1, 2024.
If you have any queries about the taxation of Social Security benefits, please contact our office.
