Amazing Retirement Planning Facts About How Social Security is Taxed

Troy Sharpe: I’m going to show you today some really cool examples of how Social Security is taxed. I’m going to clear up some misconceptions, but then I’m also going to show you how to do this calculation yourself.

Troy: Hi, I’m Troy Sharpe, CEO of Oak Harvest Financial Group, certified financial planner professional, host to The Retirement Income Show, and also a certified tax specialist. I feel like for more than 10 years now, we’ve been way ahead of the curve. As a retirement planning firm, we’ve been telling people to do Roth conversions, to consider taxes when you look at your income in retirement, to do all of these various things that are specific to retirement planning, that most accumulation phase advisors are maybe just now or not even coming around to.

Today, I’m going to share another one of those concepts that we’ve talked to our clients about and I’ve shared even on the YouTube channel before, but it’s not just about how your Social Security is taxed, it’s how your Social Security election strategy, the taxation of those benefits, how that works into an overall retirement income and tax strategy.

Too often, people say you should defer Social Security to maximize your benefit, but what they overlook is the power of how Social Security is taxed, and how that can improve everything inside your retirement. For some of you, it may make sense to take Social Security sooner or later, everyone is different. I just want to convey in this video the power of how Social Security is taxed, clear up some of those misconceptions, and help you, whether you reach out to us, you work with your advisor, or you’re just a DIYer, so you can understand how Social Security and the taxation of it can be a very, very powerful planning tool in your retirement toolbox.

Hey, just a brief interruption here. If you like the content, if you’re learning about Social Security and taxes, make sure to subscribe to the channel, comment down below, and hit that like button if you enjoy it.
One of the main points I’m going to get across today is that you can have a whole lot of Social Security income and pay very little if any tax, but once you start to introduce other forms of income in retirement, all of a sudden, the taxation of not only that income, but the Social Security income can jump significantly. One of the misconceptions is, when we look at, let’s say you’ve read an article about how Social Security is taxed, or you’ve done some research, and you’ve really read.

I used to get in these conversations all of the time with clients, with people who come in and see me because you read something, and this is right from the Social Security Administration and it’s talking about the income thresholds that determine how much of your Social Security is subject to tax. If you’re a single filer or an individual and your combined income is between $25,000 and $34,000, you may have to pay tax on up to 50% of your benefits. More than $34,000 of combined income, up to 85% of your benefits may be taxable.

25 to 34, and then more than 34, you get into the 85% of your benefits are taxable. That doesn’t mean 85% tax rate, it says up to 85% of the benefits received could be taxable. The key wording here is it says you may have to pay income tax on up to 50% of your benefits. If you file a joint return, these income thresholds are between $32,000 and $44,000 for 50%, up to 50%. Then more than $44,000 of combined income, it’s up to 85%.
First off, what is combined income? It is what we call your provisional income. Essentially, it is half of your Social Security benefits. If you have $50,000 of Social Security, only half of that goes towards that calculation, and then you add back any non-taxable interest from muni bonds, for example, plus any other income that you have.

Most people, when they read an article, they’ll get that understanding, but it’s the actual calculation itself where most people go wrong. Key takeaways [00:04:10] here are here your income thresholds, but the wording is you may have to pay income tax on up to 50% or 85% depending if you’re single or married.

I’m actually going to show you the worksheet and we’re going to have this link down below in the description. This is directly from the IRS, but I’m going to give you another link where you can actually go and calculate this yourself. It’s the exact same worksheet. It’s just in a link where you can input all the numbers right there and then spit out an answer. Pretty cool.

This is actually the worksheet. This is Publication 915. It is page 16 of the PDF. We’ll have again this PDF in the description a link to it, as well as that calculator so you can do this calculation yourself. I want you to just work through this worksheet yourself, just enter either fictitious numbers or the numbers from your actual tax return from last year. If you’re taking Social Security, add it in. If you’ve not yet begun Social Security, put your projected amount in, but work through it. This will really help you understand how that calculation unfolds and help you understand better about the taxation of your Social Security.
Let me give you an example here. If we switch over to this link, first and foremost, you’re going to put in if you’re married, filing jointly, your marginal tax bracket, so this is the next dollar that you would earn, what rate would it be taxed at. Here, we would put in any of these income sources that we have. If we have IRA distributions, for example, they’d go here. If we have municipal bond interest, if we have dividends or capital gains, bond interest, a pension benefit, pretty self-explanatory.

For the purpose of this illustration, I’m going to put nothing in here. Then for Social Security benefits, I’m going to put $80,000. Now, if we think back to the previous slide, and what I told you, you would say, “Okay, if I have $80,000 of Social Security, no other income,” provisional income would be $40,000. One-half of the Social Security benefits. If I’m married, filing jointly, that falls between the $32,000 and $44,000 threshold.

I would think that 50% of my Social Security benefits are taxable. That would mean $20,000 of that $40,000 would be subject to income tax, and I’d be paying tax on that. The truth is, so we see, we have the $80,000. This is the $40,000, the one-half number. This is the entire worksheet that I showed you over here, the IRS Publication 915, page 16 of the PDF. This calculator just does all the inputs for you. This is that worksheet. It’s done for you.
We see that and then we start to go through all of the other points of the worksheet. This is why I want you to work through it because it just will be beneficial if you do. Then we get down here and it says the taxable Social Security benefit is $4,000. It’s not $20,000 because if we just read an article and it says if you fall in between this $32,000 to $44,000 because our provisional income was $40,000, that up to 50% of the benefit is taxable.

Keywords are up to 50% of the benefit is taxable. Doesn’t mean it’s 50% taxable. It’s actually because of the calculations in the worksheet, only $4,000 of our $80,000 Social Security income is subject to tax, but it gets better.
This worksheet, it has one flaw here. It’s not taking into account your standard deduction or your itemized deductions if that’s what you do. This $4,000 number is actually, it goes towards our adjusted gross income. Here is the actual full tax calculation. Once we go through that $80,000 of Social Security, we get the same $4,000 number but that’s not what subject to tax, it’s part of our gross income.

Modified adjusted gross income, $4,000. We then have our deduction, so this is a standard deduction. Taxable Social Security, $4,000. Total tax, zero. $80,000 of Social Security income, zero income taxes. I’ve received this comment sometimes when I do the Roth conversion videos or financial planning videos, and I’ll show on the ledger for those of you who follow the channel, and you’ll see $80,000, $90,000, $70,000 of Social Security income, but zero taxes. I get comments all the time, “Troy, I don’t understand. What am I missing? Why can you have that income and not pay any taxes?” This is why. This is why I’m showing you this.

I’m going to show you some examples for single people as well, but let’s say we have $100,000 of Social Security income. 100,000, our number comes to 11,100. That’s what’s taxable for Social Security, but we get our deductions, the standard deduction, which again brings our total tax down to zero.

When we’re looking at income planning, tax planning for retirement, and also Social Security planning, this is what we do for clients when we look at a full comprehensive retirement plan. This is what so much of the industry overlooks. One of the reasons to consider deferring your Social Security is, one, it gives you more time and space within your income brackets to do Roth conversions because if we’re doing Roth conversions while deferring, we can take Roth distributions if we need additional income later in life, and that doesn’t increase our modified adjusted gross income, which means our Medicare premiums won’t potentially go up, net investment income tax won’t come into the picture, and it won’t increase the taxation of any of your Social Security benefits.

If you remember earlier, I said the calculation for provisional income you add back, it’s one-half of your Social Security benefits, plus any other income, plus one-half of your non-taxable interest like municipal bonds. Roth IRA distributions don’t count towards that non-taxable interest, it is a tax redistribution but it doesn’t go towards that calculation. When we’re considering do we defer Social Security, it’s not just how long you will live, it’s not just how much income will you receive, it’s not just, am I better off keeping more money in my portfolio and taking Social Security, versus allowing Social Security to defer and taking income out of my accounts.

It’s also, how does it impact my tax plan? Because if we defer Social Security, and you think there’s a pretty good chance you’re going to make it to 84, 85, 86, then deferring till 70 mathematically is probably the right decision. The reason I say probably is because you also should take into account the time value of the money, but that’s another video, that’s another discussion.

If we’re going to take into account the time value, or the opportunity cost of taking money out of the portfolio versus Social Security deferral, we also have to take into account the taxation of our future income and also the taxation today. That’s a little bit deep down a rabbit hole, main point here is understand there are powerful amazing tax benefits when it comes to Social Security and how it’s taxed in this country. Most people don’t understand this calculation.

Now, I have an example where I’m going to show you the same $80,000 of Social Security income, but combined with $80,000 of IRA distributions. Now, this may be a required distribution because you’ve not done any Roth conversions leading up to age 72, but I just want to show you how you lose the powerful benefit of Social Security taxation, the planning aspect to it if you don’t do any planning leading up to it, and we’re stuck with these big required minimum distributions later in life.

We have the same 80,000 as Social Security, 80,000 of IRA distributions, adjusted gross income’s 148,000, we get our deduction, but now look, $68,000 of our Social Security is subject to income tax. I’m pretty sure this is the 85% of that benefit. $18,000 in taxes, so the question never is, will we pay taxes in retirement? You absolutely are going to pay taxes in retirement. The only question is, when do you pay those taxes, and how much tax do you pay?

If we proactively were looking at Roth conversions targeting a customized income and tax plan for you, it may make more sense to pay the taxes earlier in life, defer Social Security because then based on inflation, based on your needs. Maybe your concerns about the market crashing later in life, your concerns about taxes being higher, there is nothing more secure than having a significant amount of tax-free income being deposited into your bank account every single month when you’re 70, 75, 80-years-old, whatever that number you live to. It’s very very secure.

Now, the next example I want to look at is $60,000 of Social Security and a $40,000 IRA withdrawal. We see that here, IRA 40, Social Security 60. This causes 28,000 of our Social Security benefits to be taxable, but an ordinary income tax of only $4,700. This isn’t horrible, and this is one reason when we’re looking at planning into the future, we have to extrapolate out your estimated account values, required minimum distributions, income taxes, and then also the situation today, and have this discussion over what makes the most amount of sense.

This is not a bad situation to be in. This is one argument towards not converting all of the IRA over to Roth and oftentimes that doesn’t make sense at all. The point is, even if we have an RMD of $40,000 later in life with $60,000 of Social Security, it’s not that bad of a tax situation. Now, if taxes are higher in the future, this is a consideration, something maybe we want to get more of the Roth converted to reduce the RMDs, therefore our IRA distributions are less, but just something for you to think about.
Now, I also wanted to show you what’s called the tax torpedo. The Social Security tax torpedo. Now, I’m not going to go too in depth about this, because it’s not tremendously consequential, but it is something you should be aware of.

All I’ve done here is we still have $60,000 of Social Security, but I’ve increased the IRA distributions to $65,000. This increases the tax up to $11,132, but here is the torpedo. This is what we call a tax map. Essentially because of how Social Security is taxed. When we take one additional dollar from the IRA, if we’re at a certain level, it causes either 50 cents more of your next Social Security dollar to be taxed or 85 cents of that $1 to be subject to income tax. It’s a bit complicated. You can Google the Social Security tax torpedo to learn more about it.

If we just pulled $60,000 out instead of $65,000 of this IRA distribution, our tax liability would be right here. Because the tax torpedo, when we look at the tax map, we’re actually getting taxed 40% on these dollars right here even though we’re nowhere near the top tax bracket.

To sum that up because I know it is confusing, essentially, it’s certain income levels of IRA distributions. If we take an IRA distribution, it brings us to a certain income level. It brings into taxation another either 50 cents or 85 cents of every $1 received from Social Security. Once we get through that threshold, it evens out, but it’s something to be aware of.

Now I want to look at just a single example. If you’re a single filer and you have Social Security, the numbers are very similar. Here, we have a single filer with $48,000 of Social Security, paying zero in income tax.
Some of you may be saying, “Troy, how do I get $48,000 of Social Security?” If we look at the maximum amounts for Social Security, if you file at 62, your maximum benefit is $2,364 per month. Someone who files at full retirement age is $3,345 per month. Someone who defers all the way to age 70 right now, the maximum Social Security income check you could receive is $4,194 per month. You do not have to make $200,000 a year for 35 years in order to receive the maximum benefit. If you have a middle-class job for 30, 35 years in this country, you’re probably going to qualify for something very, very close to the maximum Social Security benefit at full retirement age.

If you decide to defer it until 70, you could have almost $4,200 per month. That is why I wanted to show you this example of Social Security of $48,000 because if you’re a single filer and you have Social Security of anything less than that and no other income sources, you’re paying zero in total tax.

Now, if we look at a single filer that has $48,000 in Social Security and $40,000 of other income, in this example is an IRA distribution, but this could maybe be a pension, this could be bond interest, the tax amount due would be a little different for sure if it’s dividends or capital gains because we have special tax rates for dividends and capital gains as well, but I just wanted to point this out. That extra $40,000 of IRA distribution essentially is being taxed at about 20% because we know the Social Security is being taxed at zero if we didn’t have those so we’re paying about 20% as far as the total tax liability.

Now, in actuality, 30,000 of your Social Security becomes taxable, so it brings that in. We have provisional income of 64,000 which is one-half of Social Security. 24,000 plus any other income, 40,000, brings our total tax to $8,000. As we can see here, there are a lot of different decisions that need to be made when it comes to your income planning and tax planning and retirement when you take Social Security. How does that impact your taxes? Where do you take your other income from? How does that impact not just your taxes today, but your taxes in the future? Should you do Roth conversions? Should you not do Roth conversions? All of these things determine how much security you have in retirement.

Again, I want to remind you. It’s not if you’ll pay taxes in retirement. For most of you, it’s when and how much will you pay. Our goal is to help you pay the least amount over time that you’re federally obligated to but by having a proactive plan of action to help you be more secure in retirement.

If you learned something today, if you benefited from this video, please share this with a friend or family member so they could benefit as well. If you subscribe to the channel, that allows you to stay connected to us which can help us keep you more connected to your money, make better decisions in retirement. Comment down below, hit that thumbs-up button if you enjoyed it, and we look forward to seeing you on the next video.