Social Security has been around for almost 90 years. It was signed into law in 1935 and was meant to be a social insurance income program for retirees 65 and older. Over the years, the way many of my clients think about Social Security has changed. It’s not one size fits all. They question
- When to withdraw
- Who should withdraw first
- How to make their money last longer
Long gone are the days of working for one company for 50 years or retiring at 65. The way we add it into our retirement planning has also changed. One important aspect is understanding how taxes affect it.
I’m going to pause and take a quick step back before we dive into taxes. The first thing I recommend anyone do regardless of their age is set up their Social Security online account. It’s fairly simple, and it’s a wise idea to educate yourself well in advance of withdrawing your funds.
1. When Social Security Is Taxable
Most people do not understand that Social Security can be taxable. By knowing the rules regarding Social Security taxation, you will be empowered to make adjustments and possibly avoid taxation on your Social Security. So many of my clients do not understand the impact taxes have when it comes to retirement and taking their Social Security.
For example, a healthy individual decides to take Social Security at age 66 with a monthly budget of $3,300. In this scenario, she can withdraw $2,000 a month from Social Security and decides to take the remainder out of her 401k. Her Social Security will be taxable. If she would have deferred her Social Security until age 70 and used her 401k for income for 4 years, then her Social Security would not be taxed for the rest of her life.
2. How To Calculate Provisional Income
Provisional income is calculated using the recipient’s gross income, tax-free interest, and 50 percent of their Social Security benefits. Once you determine your provisional income, you can determine if your Social Security is taxed.
Let’s once again use the example above to figure out this recipient’s provisional income.
We take half of her Social Security, which is $1,000 per month or $12,000 annually. Then we take 100 percent of her withdrawals from 401k, and that is $1,300 per month or $15,600 yearly. Next, add $12,000 and $15,600 and we get $27,600 a year. That is her provisional income.
IRS Chart For Single Income Or Head Of Household
Your provisional income is taxed up to 50 percent if it equals $25,000 or more. If your provisional income is $34,000 or more, it can be taxed up to 85 percent. There are different rates if you are married.
So because her provisional income is $27,600, 50 percent of her Social Security would be taxable.
3. When Social Security Is Not Taxable
Again, using the scenario above, let’s run the numbers to show when her Social Security would not be taxable.
In this example, she is going to defer her Social Security until age 70. We also have to take into account that her Social Security will have grown by 8 percent per year with a hypothetical cost of living adjustment of 4.8 percent or 1.2 percent per year for a total growth of 36.8 percent. Her yearly Social Security would now be $32,832 a year or $2,736 per month.
Provisional Income When Social Security Is Not Taxed
Half of her Social Security is $1,368 per month or $16,416 annually. Her withdrawals from her 401k equal $564 per month or $6,768 yearly. Now, we do the math. Add $16,416 to $6,768, and we end up with $23,184. This would be her provisional income.
Again, remember the IRS chart from above. She is taking out half of her Social Security and it’s less than $25,000, so it’s not taxed.
Pro Tip: I strongly recommend running the numbers for provisional income before you decide to turn on Social Security income. In our example, having other assets helped with offsetting the taxes on Social Security.
You will also want to understand how taxes will affect your other retirement accounts. You want your money to work for you and not be hit with taxes that may be avoidable.
The best tip is to know when you want to retire. Figure out your provisional income and see if there are ways to be more tax efficient with your Social Security dollars. Working with a professional who cares about your situation is the best way to accomplish your financial goals.
Pro Tip: Remember that a professional is not emotionally tied to your situation and can guide you, more objectively, through this process.
