Social Security Taxation
In retirement, income is king. However, it is not just how much income you have, it is how much of that income you can actually keep. You may have $2000 per month in income. However, if you are at a 25% tax bracket, you only get to keep $1500/month. That is a significant difference.
We know that ordinary income and distributions from your 401k and IRA are going to be taxed. We may not like it but we expect it. What you may not expect is the likelihood of paying taxes on your social security income. That’s right. Your social security benefits may be, and likely will be, taxed. Many don’t realize this. It doesn’t make sense to them. And it shouldn’t.You have paid into social security your entire working career. Now that you have started receiving benefits, you are just getting your money back. And, yet, they are taxing you on it.
This is how it works:
If you are married filing jointly, and if your combined income is over $32,000 /year ($25,000 for single), then 50% of your social security will be taxed at your ordinary income tax rate. Now, when the government calculates your combined income, they use a little bit of government math. They take your adjusted gross income and then add to that half of your social security benefits. So, the benefits you receive actually increase the likelihood that your benefits will be taxed.
If your combined income is over $44,000 ($34,000 for single), then 85% of your social security benefits will be taxed at your ordinary income rate.
What To Do Now
It is important to keep in mind that you are not taxed on all of your income, just your taxable income. If you are able to generate tax-free income in retirement, it will not only reduce your taxes on your taxable income but can also reduce, or even eliminate, taxation on your social security benefits.