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"Will I pay taxes on my Social Security benefits?" It's a common question, and the answer may surprise some people, because it's yes. Some people do get taxed on the Social Security benefits they receive.
If that news has you hyperventilating a bit, take a deep breath. It's not as bad as it might seem.
If Social Security makes up the lion's share of your retirement income, you probably won't face any taxation. But if in addition to your Social Security benefits you have a significant amount of other income that has to be reported on your tax return -- such as from a job, dividends, interest, and so on -- then Uncle Sam's hand may indeed be outstretched toward you. How big a tax bite will you face? Well, it will depend on your particular situation and your benefits and total taxable income, but it's only up to 85% of your benefits that may be taxable.
Why 85% and not 100%? Well, that's because what we, on average, pay into the Social Security system is far less than the total benefits that we receive. If you're thinking that your contributions to the system were a tax and you shouldn't be taxed twice, here's an explanation from the Social Security Administration: "In 1993,SSA's Office of the Chief Actuary estimated that the payroll tax contributions of current and future workers would equal less than 15% of the present value of their lifetime benefits (Goss 1993). Therefore, if the ratio of lifetime contributions to benefits is less than 15%, then up to 85% of benefit income can be taxed without risk of double taxation."
Image source: Social Security Administration.
The nitty-grittyThe IRS offers guidelines to help you figure out where you stand regarding the taxability of your benefits. To use them, you'll need to know your combined income, which in this case would be the total of your adjusted gross income (AGI), your nontaxable interest (such as from municipal bonds or tax-exempt bond mutual funds), and half of your Social Security benefits for the year. As you prepare your taxes, look for the Social Security Benefit Statement (Form SSA-1099) that you should receive in January. It summarizes the benefits you received during the year and will help you with your calculations. Here are the rules in a nutshell:
- If you're a single filer and in 2015 your combined income as defined above is between $25,000 and $34,000, up to 50% of your Social Security benefits may be taxed. If your combined income is more than $34,000, up to 85% of your benefits may be taxed.
- If you're married and filing jointly in 2015, combined income of between $32,000 and $44,000 means that up to 50% of your Social Security benefits may be taxed. Combined income topping $44,000 means up to 85% of your benefits may be taxed.
- If you're married and filing separately, well, the SSA's guidance is rather blunt: "... you probably will pay taxes on your benefits."
You'll find more details and guidance on determining just how much of your benefits will be taxed in this section of IRS Publication 554 (Tax Guide for Seniors). It's worth remembering that you will probably be able to find answers to many or most of your tax questions at the www.IRS.gov website.
Note, too, that you may owe state taxes on your Social Security benefits. Recently, 13 statesimposed such taxes: Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont, and West Virginia.
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What to doSo how do you pay this tax if you owe it? Well, you can make quarterly estimated tax payments, as self-employed people generally do, via Form 1040-ES. Alternatively, you can opt to have taxes withheld from your benefits before they get to you, via Form W-4V. Taking care of this obligation via withholding can make things simpler, as you won't need to file estimated tax returns each quarter throughout the year.
You might also try to avoid owing any taxes on your Social Security benefits through some planning. For example, if you plan to sell a lot of stocks, generating significant capital gains income, you might try to not spread them out evenly over many years but to bunch them in certain years, where you can expect a Social Security benefit tax hit. Or, if you know that you're getting a big tax hit on them already, perhaps the full 85% of them being taxes, you might decide to harvest some stock gains in that year.
You also may be able to spread out IRA withdrawals so that the bulk of them fall in every other year, leaving the years in between with less taxable income. Having more income from Roth IRAs instead of traditional IRAs will also help, as Roth IRA income is generally tax-free.
Be prepared to possibly pay some taxes on your Social Security benefits -- but know, too, that much of them may remain tax-free, especially if you do some careful planning.
The article Will I Pay Taxes on My Social Security Benefits? originally appeared on Fool.com.
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