From my recent article on taxation of distributions, I've gotten a couple of questions on how Social Security benefits plays into the taxation of these dividends and capital gains. This kind of question inevitably leads to a discussion on how Social Security is taxed. So thought I might take a moment and explain and, more important, show how this works.
A brief description of how SS Retirement Benefits are determined
Social Security retirement benefits are derived from our work history. The Social Security (Employment) Tax is levied on us at 6.2% of only compensation income (not Adjusted Gross Income) up to a maximum of $118,500 for 2016, (indexed each year) with the employer also paying in 6.2% of compensation income. If one is self-employed (Schedule C or Schedule F), the self-employed person will pay in both halves (12.4%), but ½ of this is deductible on the front of the self-employed individual's Tax Form 1040. Thus those at or above the maximum earned income will have .124 X 118,500 = $14,694 contributed to the Social Security Trust Fund that year. It is important to note that Social Security is Social Insurance, not a savings account. Like a private pension, the benefit will be based on years of work, some measure of salary and some "participation %." And employee contributions to Social Security are made after tax… that is, contributions are not deductible for Federal Tax and I don't believe any states allow them to be deducted prior to calculating state tax (although not sure of this). However, the employer contribution is deductible to the employer.
The Social Security Administration (SSA) determines the SS benefit by taking all past years earnings and inflating them up to present value using a wage inflator (not CPI). Each year's wage inflation adjusted amount is rank ordered by size and the top 35 are added up and then divided by 35, and then by 12 (to convert from annual to monthly) to arrive at the Average Indexed Monthly Earnings (AIME). Note that SSA uses a divisor of 35 even if the worker has less than 35 years of earnings history. The AIME then goes through 3 tiers of % calculations: 90% of the first $856 + 32% of the next $5,157 + 15% over this = Primary Insurance Amount, or PIA. This is the amount one would receive if they begin their retirement benefit in the month of their Full Retirement Age, or FRA. The % participation rates above are referred to as "bend points" and are adjusted for inflation for most years. If one begins benefits prior to FRA, their PIA is decreased by a certain % per month they begin early. If one delays benefits and their FRA is 66, their PIA increases by 8%/yr up to age 70 when it no longer increases each year delayed, except by the annual inflation adjuster, if there is one. The maximum benefit for 2016 at FRA is $2,663/month.
Taxation of SS Retirement Benefits
Prior to 1984, SS Retirement Benefits were not taxed. Subsequent to a report by the 1979 Advisory Council and Greenspan Commission, Congress enacted an amendment to the SS Act that beginning in 1984, up to 50% of SS Retirement Benefits would be taxed on a sliding scale. At that time, only about 10% of SS Beneficiaries would pay tax on their SS Benefits. 10 years later, Congress passed a second amendment by adding an additional 35% to the maximum 50% base of SS benefits subject to taxation, raising the maximum to 85% of SS benefits being includable as income, by adding to the existing sliding scale. The reasoning for this came from a study of private pensions that showed over one's working years, if the employee contributed 1/2 to their pension and the employer the other half, with the employee's contribution made with after-tax dollars, the future value of the pretax employer contributions plus all pretax earnings would represent about 85% of the value of the accumulated savings.
A MAJOR provision of this taxation legislation is that none of it is indexed for inflation, unlike the computation of SS retirement benefits, all of which is indexed for inflation. (interestingly, the $255 "death benefit" paid to surviving spouses is also not indexed). Thus, while SS benefits and other forms of household income have grown, the $$ thresholds used to determine how much of one's SS must be included as income has not changed. So the percent of households having to include SS benefits as income has steadily increased from about 22% in 1994 to about 58% today… and this will continue to increase under the original rules. And because the taxes collected on SS benefits goes into the SS Trust Fund, it is unlikely indexing will be added.
Determining the amount of SS that must be included in taxed income
If one wishes to know how much of their household SS must be included in their income subject to taxation, they may go to one of several websites that will do this calculation or have their tax preparation software do it for them. But rarely, if ever, do these calculators tell you how the amount is calculated. Using a "black-box" calculator is okay, but it is always good to know how the calculation is actually done and it is also always good to be able to check the calculator to ensure it is correct.
Understanding the Calculation (it's easy)
"Provisional Income" (NASDAQ:PI) is the base amount the IRS uses in determining how much of your SS benefit must be added to your ordinary income. For most who are fully retired, this simple PI equation will apply. But it may need to be adjusted for those few who are still working, as follows:
- Add to Adjusted Gross Income (AGI) any of the following deductions that may apply: Any student loan interest deducted, tuition and fees deducted or Domestic Production Activities deductions. Also add any employer provided adoption expenses or foreign earned income or foreign housing benefits not included in income. (this apply to anybody?.... No?... Good! Didn't think it would)
- Household SS benefits are from box 5 of Form SSA-1099 of each spouse if married filing jointly. This is the gross amount of SS benefits, which may not be the amount actually received. If you have begun receiving benefits this year, the Social Security Administration should have sent you a letter of benefits, showing the gross benefit before any deductions for Medicare Part B premium or tax withholding. Always include the gross amount of SS benefits received, minus only returns (if SS overpaid you).
Muni-bond interest is bond interest not included in your AGI, as shown on line 8b of Form 1040. This must be included in the PI.
Note that there are forms of household income that are not included in your AGI that are also not included in the PI. These include gifts, investment return of capital or return of principal in an insurance product or that part of a traditional IRA withdrawal that represents the after tax portion of the withdrawal, or qualified Roth IRA distributions.
The "Base Amounts" and determining taxable SS
There are two base amounts each for those filing single (S) and those filing Married Filing Jointly (MFJ):
- If your PI is less than the first base amount for your tax filing status, none of your SS benefit will be included as income.
- If your PI is greater than the first base amount but less than the second base amount, then the amount of your SS that you must include as income (line 20b of your Form 1040) will be the LESSER OF
- 50% of your household SS benefit
- 50% of the amount your PI exceeds the first base amount
3. If your PI is greater than the second base amount, then the amount of your SS you must include as income will be the LESSER of
- $4,500 or $6,000 (MFJ) + 85% of the PI over the second base amount.
- If the annual household SS benefit is less than $9,000 or $12,000 (MFJ), then use 50% of the SS benefit instead of $4,500 or $6,000 (MFJ)
- 85% of PI
A couple has retired this year and began their SS benefits at ages 64 and 62. Both have elected to delay the start of their pensions until their retirement plan's full retirement age next year (her) and the year after that (him). She had a 16-year work record with her employer while he had a 35-year work record with his. Most of their personal retirement savings they have made to their Roth IRAs (RIRAs) with some earlier savings contributed to their Traditional IRAs (TIRAs) before the advent of RIRAs. They also have taxable accounts holding primarily Exchange Traded Funds that pay a mixture of qualified dividends and non-qualified dividends and interest. They also invest in a muni bond fund. They file jointly having the following household income:
Because their PI is less than $32,000, none of their SS benefits must be included in income for this year.
At the beginning of the next year, she begins her pension from her previous employer. All other forms of household income remain unchanged.
Because the PI at $42,250 is greater than the first base amount of $32,000 but less than the second base amount of $44,000, the amount of SS that must be included as ordinary income will be the lesser of:
.5 X $32,000 = $16,000, or
.5 X [$42,250 - $32,000] = $5,125
Thus, $5,125 must be added to ordinary income (line 20b of Form 1040).
At the beginning of the next year, he begins his pension benefit from his former employer. All other forms of household income remain the same (whew… I think I'd look for another dividend ETF!)
With the PI now at $72,250, this exceeds the second base amount of $44,000, so the amount of SS benefits that must be included this year as ordinary income will be the lesser of:
.85 X $32,000 = $27,200, or
$6,000 + (.85 X [$72,250 - $44,000]) = $30,013
Thus, this couple will have to include 85% of SS ($27,200) as ordinary income. Depending on future TIRA withdrawals and dividend + interest income, this couple will most likely be in the "85% Bracket" for inclusion of SS benefits for the rest of their lives, as AGI will almost certainly rise over the upcoming years, but the base amounts used in calculating the PI will remain fixed.
Being able to estimate how much of one's SS benefit must be included as income will help in making the correct quarterly estimated tax payments or in helping to determine the best percent tax withholding on SS benefits. One could certainly use an online calculator or one could simply set up an Excel SS or even a calculator, pencil and paper, and do their own calculations. As I've shown, this calculation isn't really that difficult, and it will clearly show how you arrived at your results.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.