After paying taxes on earnings during your entire work career, you may finally be entitled to receive Social Security retirement benefits. But be aware that those benefits could come at a tax price. Depending on a complex calculation based on two tiers, you might have to pay federal income tax on a portion of the benefits.
The tax liability for Social Security benefits depends on a two-tier system that takes your "provisional income" (PI) into account. PI is defined as the total of three amounts: (1) your adjusted gross income (AGI) for other tax purposes, (2) tax-exempt interest income, like municipal bond interest, and (3) 50 percent of the Social Security benefits received. For example, if you have an AGI of $100,000, municipal bond income of $5,000, and Social Security benefits of $20,000, your PI is $115,000 ($100,000 plus $5,000 plus $10,000).
The calculation for taxing Social Security benefits under the two tiers is complex. Without going into all the details, here's what you need to know. If your PI falls between the lower threshold of $32,000 and upper threshold of $44,000 for joint filers (between $25,000 and $34,000 for single filers), up to 50 percent of your benefits are taxable. If your PI exceeds the upper threshold, up to 85 percent of your benefits are taxable. Thus, if you reach the second tier, you're taxed on a larger share of the benefits. In addition, the thresholds for the two tiers aren't indexed for inflation, so the tax will continue to kick in at relatively modest levels.
How can you reduce your tax liability for Social Security benefits? Keep an eye on the PI components. For instance, you might lower your AGI by postponing capital gains from securities sales to next year or taking losses this year to offset gains. It's wise to consider all the relevant factors before you make any moves. Call if you have questions.
