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Effect of Taxes on the Social Security Filing Decision

There has been a rise in the number of Americans who depend on Social Security as their financial lifeline after retirement. Social Security is a community welfare system that was established in the US in 1935, as a way to guarantee a yearly income throughout the life of the beneficiary. However, to plan for your retirement more efficiently, you need to understand some key facts about Social Security.

A glimpse into Social Security

Eligibility for full Social Security Benefits (SSB) begins between the ages of 62 and 67.

  • The amount of benefit you receive depends on the age when you choose to file for it.
  • The amount you receive per month also depends on your earnings during your working life.
  • Your legal spouse, as well as your widow, could receive benefits even if they have never earned a salary.
  • Depending on the year of your birth, the age of 66 or 67 is usually regarded as full retirement age (FRA). At this age, you can claim 100% of your benefits.
  • If you delay Social Security Filing up to the age of 70, your benefits can increase by almost 8% per year for each year you holdup.

What are the terms of taxation on Social Security?

Every year in January, you will receive the Form 1099-SSA, which is your Social Security Benefit Statement. To find out your total income from Social Security in the previous year, you can refer to this form. Your Social Security Benefit is not liable to taxation when it is your sole source of income. However, you will have to pay taxes on your Social Security Benefits if:

  • Your income as an individual exceeds $25000 and is more than $34000 if you file jointly with your spouse.
  • You are still working for wages when you start to receive Social Security.
  • You have earnings from other sources.

Additional taxable sources of income comprise of:

  • Earnings from self-employment
  • Income from investments like dividends or interests
  • Capital gains
  • Income from rental property
  • Annuity or pension proceeds
  • Withdrawals from IRA/401(k)/403(b)

Please note that withdrawals from Roth IRA are not liable to taxes

The sum total of your combined income decides whether you will be taxed on your Social Security Benefit. You can calculate your combined income according to the following formula:

Half the amount of your Social Security Benefit + Interest amounts that are not taxable + Adjusted gross income (AGI)* *(AGI = sum of all income as on lines 7-22 of Form 1040 minus all above-the-line deductions or exemptions allowed in that fiscal year)

Federal Taxes

Percentage of SSB liable to Taxation = 50% Portion of SSB liable to Taxation = 85%
Individual Taxpayers Combined Income amounts to $25,000 to $34,000 Combined Income Exceeds $34,000
Taxpayers filing jointly with their spouse Combined Income amounts to $32,000 to $44,000 Combined Income Exceeds $44,000

This rule applies to retirement benefits as well as survivor, spousal, and disability benefits.

You must also know that currently the following 13 states in the US charge tax on Social Security to different degrees. These states are:

  1. Colorado
  2. Connecticut
  3. Kansas
  4. Minnesota
  5. Missouri
  6. Montana
  7. Nebraska
  8. New Mexico
  9. Rhode Island
  10. North Dakota
  11. Vermont
  12. Utah
  13. West Virginia

Additionally, you must note that State Taxation of Social Security is being phased out in West Virginia. From the assessment year 2021, most residents will not be taxed on the benefits.

Tax planning in your retirement

Your decision to file Social Security Benefit should factor in tax efficiency. In usual cases, you will receive more favorable tax treatment on your income from Social Security than your retirement proceeds from IRAs or 401(k)s. You need to pay a standard tax rate on income from such retirement accounts, except for a Roth IRA. However, you will never be required to pay taxes on the full amount of your SSB. The significance of this is that one dollar of your SSB has more worth than one dollar of withdrawals from IRA. You can pay a lesser amount of tax if you prepare a retirement plan taking benefit of this tax arbitrage.

The benefit of delaying without considering taxation

Coming to a decision can be complicated even when tax is not considered. Usually, people tend to claim Social Security at an age that is too early in comparison to the optimal age for claiming benefits. You can potentially sign up for Social Security at the age of 62. However, if you want to claim the entire amount scheduled as per your work record, you should consider waiting until your FRA.

If you start early, you will get only 70% of the expected amount when you file at 62, and your FRA is 67. In case your FRA is 66, you will be able to avail only 75% of the amount. If you delay until the age of 70, you will reach your maximum benefit amount. It is 132% of your scheduled amount in case your FRA is 66 and 124% when your FRA is 67.

Timing your decision for Social Security Filing keeping taxation in mind

Timing your decision for claiming Social Security in the right manner is crucial for planning your retirement tax strategy. Individual cases are unique to their particular requirements. Nevertheless, taxation affects decisions on when to file for Social Security. It is advisable to take into account the taxability of SSB, because the threshold for combined income is not indexed for inflation. Consequently, an increasing number of retired persons will have to pay taxes on SSB.

The important thing to note here is that when you are not receiving Social Security, you will not be charged taxes on it either. Delaying benefits will increase the amount you receive as benefits and reduce your taxable income as well. You can use the higher amount of your SSB for your expenses and reduce the sum that you have to withdraw from your retirement savings. Increasing the SSB portion towards your expenses in turn lowers your AGI. Moreover, only half on the amount of your SSB will be included in your combined income computation. The increased amount that you receive as benefits will no doubt increase your combined income. However, the diminished AGI will counteract this at least to some extent. Thus, for people who draw on non-annuitized taxable sources of retirement income like IRAs or Traditional 401(k) accounts, the optimal strategy for tax management would be to delay Social Security Filing.

To sum it up

Social Security is an assured retirement tool. However, only right planning can help you enjoy the full benefits of the scheme. When you decide to claim SSB, you must consider your life expectancy, your monetary competence to delay claiming benefits, and the magnitude of the impact the Social Security Filing will have on your income tax.

For a detailed plan and expert guidance on tax management during your retirement years, talk to top Financial Advisor today and retire stress-free without having to worry about your finances.

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