“Stealth Taxes” – How to Avoid Getting Taxed on Social Security Benefits

Bob Carlson


Have you heard of “stealth taxes?”

I call them that because people often don’t know about the taxes before getting bit by them.

One of the worst stealth taxes for retirees is the income tax on Social Security retirement benefits.

Some aren’t aware of the tax when they retire.

Others are exempt from the tax when they retire, and don’t realize that they’re likely to be hit with it later in retirement.

The reality is, the percentage of Social Security beneficiaries who pay income taxes on their benefits rises each year, as does the percentage of total benefits paid in taxes.

The tax is written to have these effects:

About half of all Social Security beneficiaries owed some income taxes on their benefits in 2014, according to the Congressional Budget Office (CBO).

The higher a retiree’s income, the higher the percentage of Social Security benefits paid in taxes.

Beneficiaries with incomes below $40,000 owed less than 0.5% of their benefits in federal income taxes in 2014, according to the CBO.

Those with incomes over $100,000 owed 21% of their benefits in taxes. A taxpayer in the highest income tax bracket would pay 33% of their benefits in federal income taxes.

Note that Social Security benefits originally were tax free. Congress imposed taxes on some Social Security benefits in two stages, in 1984 and 1994, to arrive at the current law.

The amount of your benefits that are taxed is determined by your modified adjusted gross income (MAGI), or combined income.

Adjusted gross income (AGI) is the last line on the first page of the standard Form 1040.

I’ll explain how that is modified to arrive at MAGI, or combined income, and determine the amount of your Social Security benefits that are taxed.

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Social Security benefits are still tax free when your MAGI is below $25,000 for single taxpayers and heads of household, or $32,000 for married couples filing jointly.

Up to 50% of Social Security benefits are taxed when MAGI is $25,000 to $34,000 for singles and heads of household, or $32,000 to $44,000 for married couples filing jointly.

When MAGI exceeds $34,000 for singles and heads of household, or $44,000 for marrieds filing jointly, up to 85% of the benefits are taxed.

MAGI, of course, starts with AGI. Then, you add any tax-exempt interest earned during the year, plus 50% of your Social Security benefits.

All Social Security benefits were excluded from AGI on your tax return at this point, but you add 50% of the benefits to AGI to determine if any of your benefits are taxed.

These types of income are also excluded from AGI: interest from qualified U.S. savings bonds; employer-provided adoption benefits; foreign earned income or foreign housing; or income earned in American Samoa or Puerto Rico by bona fide residents.

The IRS provides a worksheet in Publication 554 (available free on the IRS website at www.irs.gov) to help calculate MAGI.

When your income is in one of the taxable ranges, note that “up to” 50% of your benefits can be taxed in the first range and “up to” 85% of benefits in the second range.

The exact amount of your Social Security benefits that is included in gross income depends on the interplay between the amount of your benefits and the total of your other income.

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There’s a worksheet in the instructions for Form 1040 to help determine the amount of your benefits that is included in gross income, or you can use tax preparation software or a professional tax preparer.

The tax on Social Security benefits is especially onerous because it substantially increases your marginal income tax rate. That’s the tax rate on your last dollar of income.

Let’s say you’re single and your income for the year was going to be $24,999, so none of your benefits would be taxed.

Then, you unexpectedly receive another dollar of income for the year. Now, you are taxed on, not only that dollar, but also at least 50 cents of Social Security benefits.

Until you’ve included the maximum amount of Social Security benefits in gross income, your marginal tax rate on each additional dollar of income is high.

Unlike many other tax provisions, the thresholds for including Social Security benefits in gross income aren’t indexed for inflation.

As inflation and growth increase incomes generally, and Social Security benefits in particular, the percentage of retirees paying taxes on their Social Security benefits increases.

When the tax was introduced, a small percentage of beneficiaries paid taxes on their benefits. Now, about half do, and that percentage is going to increase steadily.

Don’t forget that while some states exclude all Social Security benefits from their income taxes, many states mirror the federal tax code. You’ll owe both federal and state income taxes on your benefits.

You can’t reduce taxes on Social Security benefits by taking some of the usual tax reduction strategies, because the modified definition of income requires you to include normally exempt income such as tax-exempt interest.

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Also, itemized expenses, such as charitable contributions, don’t help reduce taxes on Social Security benefits.

To avoid or delay taxes on Social Security benefits, you need to reduce the modified version of income that determines whether or not benefits are taxable.

The best ways to do that are to pay attention to your income during the year and manage sources of income over which you have some control. For example, you can avoid taking distributions from traditional IRAs and deferred annuities once your income is near the threshold.

On the other hand, if you have a Roth IRA, it would be better to take additional money from that instead of other accounts. Roth IRA distributions aren’t included in gross income and don’t increase taxes on Social Security benefits.

Also, consider Social Security taxes when managing investments. Selling an asset and recognizing a capital gain could trigger or increase taxes on benefits.

It might be better to sell an asset with a capital loss or a modest gain, than an asset with a substantial capital gain, to raise cash.

You don’t want taxes to dictate your investment decisions, but you want them to be a consideration.

You can also reduce AGI if you have a net capital loss or losses from a business activity. These reduce adjusted gross income, and so reduce taxes on Social Security benefits.

Reducing taxes on Social Security benefits can be a year-long activity. You want to pay attention to your total income and its sources.

When possible, manage your sources of income to eliminate or reduce taxes on your benefits, and make sure you include any taxes on Social Security benefits in your quarterly income tax deposits.

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