As we approach the end of 2024, Social Security and CMS (Centers for Medicare and Medicaid Services) recently released their annual updates. Social Security recipients will see a 2.5% cost-of-living adjustment (COLA) for 2025. For the national average Social Security benefit of $1,800 per month, those recipients will see a $45 monthly bump. However, CMS has announced the standard Medicare Part B will rise by $10.30 a month from $174.70 to $185.00, offsetting some of the COLA increase.
Inflation has been a pressing concern in recent years. While the COLA increase helps maintain purchasing power, it also draws attention to another important issue for retirees that affects purchasing power: the taxation of Social Security benefits.
Many retirees are surprised to learn that their Social Security benefits may be subject to federal income tax. As a wealth advisor, I often find that retirees don’t fully understand how Social Security is taxed or why more and more retirees are finding a portion of their benefits taxable. The reality is that Social Security benefits can be taxed at varying rates depending on your total income, and there are factors that cause this situation to become more common over time. In this post, we will explore how Social Security benefits are taxed, what income levels trigger taxation, and why this issue is becoming increasingly important as inflation and life expectancy rise. We will also discuss the importance of survivorship analysis in retirement income planning and how the death of a spouse can impact the taxation of Social Security.
Understanding the Taxation of Social Security Benefits
Social Security benefits are not automatically exempt from taxes. In fact, depending on your income, you may pay federal income tax on a portion of your benefits. The amount of your Social Security that is subject to tax depends on your provisional income, a figure that includes your adjusted gross income (AGI), nontaxable interest, and half of your Social Security benefits.
Here’s a breakdown of how your provisional income is calculated:
Adjusted Gross Income (AGI): This includes income from pensions, wages, rental income, interest, dividends, and distributions from retirement accounts such as IRAs or 401(k)s.
Nontaxable Interest: For example, interest earned on municipal bonds is typically not taxable at the federal level.
Half of your Social Security benefits: This is a key factor in determining whether your benefits will be taxed.
Once you calculate your provisional income, the IRS applies specific income thresholds to determine whether your Social Security benefits will be taxed. These thresholds are based on your filing status:
For single filers:
If your provisional income is below $25,000, your Social Security benefits are not taxable.
If your provisional income is between $25,000 and $34,000, up to 50% of your Social Security benefits may be taxable.
If your provisional income is above $34,000, up to 85% of your Social Security benefits may be taxable.
For married couples filing jointly:
If your provisional income is below $32,000, your Social Security benefits are not taxable.
If your provisional income is between $32,000 and $44,000, up to 50% of your Social Security benefits may be taxable.
If your provisional income is above $44,000, up to 85% of your Social Security benefits may be taxable.
One extremely important thing to note is that these income thresholds are not adjusted for inflation! While the annual COLA increase for Social Security recipients helps to keep pace with rising costs of living, the tax threshold has not changed since 1993. This means that over time, more and more retirees will find themselves paying taxes on their Social Security benefits as their income from Social Security as well as other sources (such as retirement savings or pensions) increases.
This is an issue that’s becoming increasingly common as inflation and COLA adjustments continue to drive up Social Security payments. Over time, more retirees are likely to find themselves facing
taxation on their benefits simply because their benefits are increasing, but the tax thresholds remain unchanged.
How the Phase In of Social Security Taxation Affects Other Strategies
The jump from 0% of Social Security being taxable to 50% of Social Security being taxable is not a cliff, meaning going $1 over the provisional income of $32,000 as a married couple does not make 50% of your total benefit taxable. However, consider that while you are “phasing in” to taxation of your Social Security benefits, for every $2 in additional provisional income you add, $1 of your Social Security becomes taxable. Therefore, for every $2 of provisional income you add, $3 becomes taxable!
This becomes important to consider as we analyze year-end tax planning opportunities. While a retiree may be in the 10% or 12% marginal tax bracket, each additional dollar of income may actually be taxed at 18.5% or 22.2% due to the phase in of Social Security taxation. While certain year-end strategies like Roth Conversions may make sense on the surface, the actual benefit may be much less after factoring in the additional taxes on Social Security benefits.
The Impact of Survivorship Analysis on Social Security Taxation
One factor that many retirees overlook is what happens to their Social Security and other income sources if one spouse passes away prematurely. If you are married and your spouse passes away, you may be left with a significantly higher taxable income than you had previously. When one spouse dies, the surviving spouse typically receives the higher Social Security benefit — either their own benefit or the deceased spouse’s benefit, whichever is higher.
Due to the loss of one Social Security benefit, the surviving spouse may need to tap into their retirement accounts (such as an IRA or 401(k)) to supplement income, especially if the deceased spouse had pension benefits or other sources of income that are no longer available.
On top of the widow/widower moving from larger married filing joint tax brackets to more compressed single tax brackets, 100% of IRA distributions are taxable instead of only 85% of the deceased spouse’s Social Security benefits. For example, $1,000 in Social Security benefits would at most add $850 of taxable income to a tax return whereas $1,000 of IRA distributions will add $1,000 of taxable income (and could increase Social Security taxation if still in the phase in)!
This underscores the importance of survivorship analysis in retirement income planning. By considering the tax implications of a surviving spouse’s income needs, you can plan for the possibility that your Social Security benefits may be taxed more heavily in the event of a spouse’s death. Working with a financial advisor to model these scenarios can help you anticipate future tax liabilities and make informed decisions about withdrawals from retirement accounts to make sure your financial plan is secure in a widow/widower scenario.
Strategies to Minimize Social Security Taxation
While you can’t control the tax thresholds or the COLA increases, there are strategies that can help minimize the taxation of your Social Security benefits:
Control your income levels: By managing withdrawals from retirement accounts and other taxable income sources, you can keep your provisional income below the thresholds for Social Security taxation. Consider delaying IRA or 401(k) withdrawals until necessary, or systematically converting some of your traditional retirement savings to Roth IRAs to create tax-free income in the future.
Tax-efficient withdrawal strategies: If you have multiple sources of retirement income, you may be able to withdraw funds in a way that minimizes the tax impact on your Social Security benefits. For example, taking withdrawals from a tax-advantaged Roth IRA or a brokerage account instead of a traditional IRA could help you avoid triggering higher taxes on your Social Security benefits.
Survivorship planning: As mentioned earlier, the death of a spouse can significantly increase the taxable income of the surviving spouse. It’s important to plan for this eventuality by considering how your retirement income will change and how that might affect your tax situation. This could include adjusting your withdrawal strategy or considering life insurance to help replace lost income.
Conclusion
The taxation of Social Security benefits and their retirement income plan is a complex issue that affects most retirees. With the thresholds for taxation remaining unchanged for decades, it’s crucial for retirees to understand how their provisional income can affect the taxation of their benefits in any given year but also over their remaining lifetime. Additionally, survivorship planning plays an important role in managing the potential tax burden that can arise after the death of a spouse.
As you approach retirement, it can be a great investment to work with a financial advisor who can help you navigate these challenges and develop a tax-efficient strategy for Social Security benefits and other sources of retirement income. By planning ahead, you can minimize the impact of taxes on your benefits and ensure that you maintain a comfortable retirement income in the years to come.
If you have any questions, please contact our office at 219-465-6924.
Mark Rosinski, CFP®, CPA
Wealth Advisor
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