Retirement Answers

Jacob: 00:00

Hey, everybody. And welcome back to another episode of Retirement Answers. My name is Jacob Duke. I'm a certified financial planner, and I help people just like you retire on a daily basis. And so today I wanted to share with you a question and a few answers around, something that I get a lot, and it revolves around Social Security and how it's taxed.

Jacob: 00:22

And we're gonna talk through, all of those different questions and walk through a couple examples to share exactly how the taxation for Social Security works because not everyone is always subject to that taxation. So let's go ahead and get started. The first thing that you have to know is, yes, Social Security is subject to taxation, and the keywords there are that it is subject to taxation, not that it is always taxed. So in fact, no matter what, no more than 85% of your Social Security income will ever be taxed. So for example, this is hypothetical because it's not possible, but let's say that you're married filing jointly and you have a total of $100,000 of social security income for the year.

Jacob: 01:05

At most, only 85,000 of that would ever be taxable. K? So 85% of any of your Social Security, that's the most that ever could be taxed. So right now in 2023, the highest possible Social Security amount is 3627 per month, but the average benefit is 1,827 per month. So obviously the average is right at about half of what the total possible maximum is.

Jacob: 01:34

So up to 85% of your social security could be taxed, but it's also possible for none of your Social Security to be taxed. Yes. You heard that correctly. It is possible that none of your Social Security could be taxed, and here's how. If your only source of income is Social Security, you will not have to owe any taxes on that at all.

Jacob: 01:56

And so you're like, wow, Jacob, that is awesome. How is this possible? Well, let's go ahead and talk through that. The first thing you have to do is you have to calculate how much of your Social Security will actually be taxed. And to do that, we had to find what the IRS calls your combined income.

Jacob: 02:12

So to put it simply, your combined income is one half of your Social Security income plus all other taxable income sources. And then also we have to add in any municipal bond or nontaxable interest. K? So those three items, one half of Social Security, all other sources of income, and then also any nontaxable interest. And by doing this calculation, what we're gonna find out is how much of each dollar of your Social Security is actually taxable.

Jacob: 02:43

So after we find your combined income, we have to run that amount through the Social Security income tax brackets, which are different than your normal tax brackets. But, just to make things simpler, instead of trying to explain it, let's just walk through an example, together. That way we can get a really good understanding. So I'm just gonna use a couple names and a couple hypotheticals. So John and Mary, they have the following Social Security income.

Jacob: 03:07

John gets 3,000 a month, and Mary gets $2,500 a month, giving them a total of $66,000 of Social Security income this year. That's their only source of income, and it meets their monthly needs. So in a minute, we'll run through this scenario again, but we'll also include IRA distributions, which would fall into that other taxable income source category and show you how other income will cause their Social Security actually to become taxable. So the first step, remember, we have to find what's called the combined income. So we take half of their Social Security, and we add it to all other sources of income.

Jacob: 03:41

So for John and Mary, we divide 66,000 divided by two. That gives us 33,000. And so now we have to add their other taxable income. And remember, in this scenario, we said that, hey. And there's no other income.

Jacob: 03:53

Their only source of income is their Social Security that's actually taxable. So there's nothing to add to that 33,000. Also, they don't have any municipal bonds or any other nontaxable interest that we have to add back as well. So next, we take this number, that 33,000, and we run it through those combined income brackets that I mentioned previously. So what are those combined income brackets?

Jacob: 04:14

Well, for married filing jointly, the brackets are zero to 32,000. Any money that falls in that 0 to $32,000 amount, 0% of that is taxable. K? 32,000 to 44,000, 50% of that amount is taxable. And then anything that is 44,000 or above, 85% of that is taxable.

Jacob: 04:39

So when he had this combined income, John and Mary's combined income is 33,000. So the easiest way to do this is to say 33,000 minus 32,000 since that's the first bracket. That means that $32,000 of their 33,000 combined income, 0% of that 32,000 is taxable, which means none of it's taxable. Right? So we take 33,000, subtract out 32.

Jacob: 05:02

That leaves us with $1,000 that would actually be in that middle bracket of 32 to 44,000, and only half of that $1,000 is subject to taxation. So we what we have is $500 of their Social Security is taxable. Okay? So $500 out of their total of 66,000 is actually how much is taxable after we figure out their combined income, run it through the combined income brackets, and then we determine how much of their 66,000 total is truly taxable. One important point that I wanna make here is that these are not all or nothing buckets.

Jacob: 05:36

They're progressive brackets, just like our normal tax brackets. So that means that 0% of the first 32,000 is subject to tax, then 50% of the next 12,000 is subject to tax, and then 85% of any, amount over 44,000 is subject to tax. So by running through these combined brackets, we're figuring out how much Social Security is actually taxable. Remember, we figured out that only $500 of their 66,000 is subject to taxation. Next, we would add that $500 that we figured out to their other income sources.

Jacob: 06:06

But since they don't have any, we don't have anything to add to it. So now that we see, hey. Their only taxable income is $500 for the whole year, we subtract out their standard deduction, which is 2023 is 27,700. We can see right away that, hey. They're not gonna pay any taxes because after their standard deduction, they have no income.

Jacob: 06:25

K? So let's run through the same scenario again, but we're gonna add, a $50,000 IRA distribution to John and Mary's income, and I'm gonna show you some of the differences here on how this is gonna work. So let's calculate that combined income again. Remember, we take one half of their Social Security income, which is 66,000, that divided by two is 33. Then the difference on this scenario compared to our previous one is that we have to add the 50,000 that they're distributing from their IRAs to that 33,000.

Jacob: 06:54

So now we have 83,000 is their combined income as opposed to only 33. So now we run that combined income through those combined income brackets like we did before. So 83,000, remember the first bracket is 32. So 83,000 minus 32,000, we have 51,000 left over, Then we have 51,000 subtract out 12,000, which is that middle 50% taxable bracket, then we're left with 39,000. So by doing it this way, I can see that 0% of the first 32,000 is taxable, 50% of the next 12,000 is taxable, and then 85% of that 39,000 that is left over is taxable, which means that $0 is taxable in the first 32, then $6,000 is taxable on the next 12, And then the last bracket, that 39,000, 33,150 of that is taxable, which brings us to a total, taxable amount of their social security.

Jacob: 07:50

How much of it is taxable? It equals 39,150. K. So right away, I want you to see one thing. By having $50,000 of an IRA distribution, the amount of their Social Security income that became taxable went from $500 to 39,150 just because of a $50,000 distribution from their IRA.

Jacob: 08:13

So that means that 59% of their Social Security is now taxable as to whereas basically 0% of that was before. So this IRA distribution alone took their Social Security income from 0% subject to taxation to 59% subject to taxation. So what does their overall tax that they actually are gonna pay come out to be? Well, we have to take that $39,001.50. That is the amount of their Social Security that is taxable.

Jacob: 08:37

Remember, we have to add that back to the other sources of income, which is 50,000 from their IRA, which leaves us with 89,150, which is their new adjusted gross income. Then And we subtract out their standard deduction, which in 2023 is 27,700. And since John and Mary are over 65, they also get an additional $3,000 of deduction, bringing their total standard deduction to 30,700. Whenever we subtract that from the $89.01 50, that leaves us with $58,450. And now we just take that amount and run that through the normal married filing jointly tax brackets.

Jacob: 09:14

So 58,450 minus 22,000, which is that first 10 bracket leaves us with $36,004.50. So 10% of 22,000 is $2,200, and then 12% of that $36.04 50 is 4,374. For a total amount of taxes that they have to pay at the federal level of $6,574 on a total income of 116,000. So this comes out to be just under a 6% effective federal tax rate. But the main thing here is that this is a lot more of tax they're gonna pay on their Social Security that they otherwise were not gonna pay whenever Social Security was their only source of income.

Jacob: 09:59

So why is it important to understand how Social Security taxation works? Well, from a retiree standpoint, I think it adds even more emphasis to, tax diversification and how important that is. Right? If your only accounts that you have money saved in are those tax deferred accounts like an IRA or a traditional four zero one k. All of those dollars are gonna be taxed whenever they're withdrawn.

Jacob: 10:22

So there would be a it would be a completely different scenario if John and Mary had a Roth IRA as well, and they were able to pull 25,000 from their traditional and then 25,000 from their Roth. Because since Roth is not taxable upon distribution, we would not have to add that in as another source of income. So that would change the calculation entirely. And perhaps I'll do another episode on that at some point to walk through that example. But, basically, the idea is, hey.

Jacob: 10:49

The more tax diversified we are, how much money we have in different different accounts like a a Roth IRA, traditional IRA, then also that taxable investment account, that gives you flexibility to pull from different sources, which could also keep your Social Security taxation low as well. Number two, I wanted to kinda point out that limiting your RMDs will lower your taxes on your Social Security for the rest of your life. Right? Because once we reach that age 72 or 73 or 75, it just kinda depends on your birth year. But whenever you reach RMD age, you're gonna be forced to take money out of those tax deferred accounts.

Jacob: 11:24

So that's a that's basically a breaking point that says, hey, once you reach that age, you have zero control over how much of your Social Security will be subject to taxation because you're gonna be forced to take money out of your IRAs, which means you're gonna be forced to pay tax on that, and it will be calculated in how your Social Security is taxed as well. And then also on top of this, whenever we think about Roth conversions or just tax planning in general, utilizing what I call your gap years becomes important. Right? Because the gap years are basically from the time you retire to the time your RMD start or even more so the time that your Social Security is taken. So let's say you retired at 60 and you started taking it at 62.

Jacob: 12:07

So your gap years are only two years, which means your your planning period is really compressed and your opportunity is compressed as opposed to, let's say you retired at 60, but then you didn't take your Social Security until full retirement age, which would be like 67. So you have a seven year period of years that you can do some tax planning, do Roth conversions, and things like that. So delaying your Social Security is often a good idea, number one, because your benefit's gonna continue to increase. But, also, it allows you to do more Roth conversions during those gap years, and it means that you'll have larger Social Security benefits in the future, and you'll pay less tax on those in the future as well because you'll have less of a distribution amount from your tax deferred accounts. So all in all, understanding how your Social Security will be taxed is important to your retirement plan, your income plan, and then also your tax plan because if we don't factor it in, we will figure out later on after the bad things are starting to happen that you have no control over how much tax you're gonna pay on these different items.

Jacob: 13:04

So, taking Social Security taxes into consideration is important for your overall retirement plan. If you can be proactive for your future taxes, you can limit the amount of taxes you'll pay throughout the rest of your life. So, hopefully, in a in a in a different episode here in the future, I'll dig more a little bit into some different scenarios there that I mentioned. If you think an episode like that might be helpful, go check out my contact information in the show notes, and you can contact me there by shooting me an email. Let me know that you'd like to hear more about some different scenarios and how Social Security taxation works.

Jacob: 13:37

So thank you so much for tuning in to today's episode, and I hope you found it helpful. So once again, my name is Jacob Duke. This has been Retirement Answers, and I look forward to speaking with you again next week. Hey, Jacob here again. Really quickly before I let you go, just wanted to say that while I believe that these ideas and strategies are potentially really helpful to you as someone who's thinking about retirement, but these are purely ideas and thoughts.

Jacob: 13:59

They are not meant to be taken as personal investment, tax, or legal advice. They are strictly ideas, and they're not meant to be personal financial advice for you specifically. Thank you so much, and I look forward to talking with you next week.