One of the biggest misconceptions about Social Security benefits is that they are tax free. And even though the politicians talk about eliminating all taxes on it, I doubt that will ever happen because we are talking about trillions of dollars the politicians won't have to spend on political favors.
During the last 23 years, I have been amazed of the fact that so many people do not know that the federal government can tax up to 85% of our Social Security benefits. So, you need to know how those taxes are calculated.
Depending on your income, up to 85% of your Social Security benefits (including retirement and benefits from Social Security trust funds, like survivor and disability benefits) can be subject to tax. Your chance of paying taxes on your Social Security benefits is higher when you have a good amount of taxable income from a job, pension, or traditional IRA, etc.
I should note here that people who only have income from Social Security don’t pay income taxes on their benefits at the federal level. That said, since like other forms of retirement income taxed by the IRS, taxes on Social Security benefits are a possibility for retirees and it is important to know how Social Security taxes are calculated for when that time comes.
Calculating Tax on Social Security Benefits
When you begin receiving Social Security benefits, every January you will receive a statement (Form SSA-1099) showing the total benefits you received in the previous year. To determine how much you may be taxed, you first need to calculate your "combined income." This is your adjusted gross income (AGI) plus nontaxable interest and half of your Social Security benefits from the year. You then take away certain deductions and exclusions. The Social Security worksheet is one of the most convoluted forms in the tax code, but here is a breakdown of what it does.
The worksheet determines the percentage of your benefits that are taxable:
- If your combined income is under $25,000 (single) or $32,000 (joint filing), there is no tax on your Social Security benefits.
- For combined income between $25,000 and $34,000 (single) or $32,000 and $44,000 (joint filing), up to 50% of benefits can be taxed.
- With combined income above $34,000 (single) or above $44,000 (joint filing), up to 85% of benefits can be taxed.
If you want to take a quick look to see whether your Social Security benefits are taxable, the IRS has a tool on its website that can help you work it out.
Once you figure out how much of your social security is taxable, you then carry that amount on Line 6b of Form 1040. That is added to your other income and taxed, based on your tax bracket and the income tax rate for that bracket.
Lump-Sum Payments
We often see lump-sum payments when people are applying for social security disability payments. This is because it can often take up to three years to get it approved (and a lawyer). When that happens, they have to pay you what you would have received from the point you applied for it.
When calculating taxes on lump-sum Social Security benefits, you have a couple of different ways to calculate them. You can just include the taxable portion of any lump-sum payment you received during the year you received it.
Or you might lower the taxable portion of your benefits by figuring how much you would have paid in taxes if you had received the money in the year you were supposed to receive it. The IRS has a form where you can elect to figure the taxable part of a lump-sum payment for an earlier year separately, using your income from the previous year. If you use a tax preparer, make sure they figure it both ways for you.
Note: Lump-sum retirement benefits differ from lump-sum death benefits. No part of a lump-sum death benefit paid by the Social Security Administration (SSA) is taxable.
Withholding Taxes from Social Security Payments
There are normally two ways that people handle withholding to cover the taxes due on the part of Social Security that is taxable. You can increase the withholding on other pension or retirement plans to cover it or you can have it withheld directly from your Social Security payments.
This is why it is so important you know how your Social Security benefits will be taxed. The last thing most people want to see at tax time is their refund turning into an amount due. If you want to just have taxes withheld from your Social Security:
- You must fill out Form W-4V and submit it to your local Social Security office.
- You can choose a withholding rate of 7%, 10%, 12%, or 22%.
Another option is to make quarterly estimated tax payments by mail or directly on the IRS.gov website. Regardless of the method, the goal is to ensure you have paid enough tax to avoid an underpayment penalty from the IRS when you file your income tax return. (The IRS imposes an underpayment penalty if you haven't prepaid at least 90% of what you owe in taxes in the current year or 110% of what you owed in the previous year.)