Social Security benefits first became partially taxable in 1983, and the rule was expanded in 1993 to its current form. As the rules stand now, rising income can subject 50% or even 85% of Social Security benefits to taxation, until a maximum of 85% of all Social Security benefits are included in income for tax purposes.
The reason the taxability of Social Security matters is not just that it raises a client's tax burden in the aggregate, but that it can boost a client's marginal tax rate far above the tax bracket alone; those in the 15% tax bracket may actually face marginal rates of 22.5% to 27.75%, and those in the 25% tax bracket can see marginal tax rates spike as high as 46.25%!
Fortunately, this rate eventually reaches a cap - when the maximum amount of Social Security benefits are being taxed - and the client's tax rate returns to normal. Nonetheless, while clients are going through the income levels where Social Security phases in - which can begin with as little as $25,000 of income for individuals - tax rates rise high enough that more proactive tax planning, from Roth conversions to the use of annuities and asset location strategies, becomes crucial to manage a client's overall tax exposure!
Taxability Of Social Security Benefits
In order to determine the taxability of Social Security benefits, it's first necessary to calculate "provisional income" - a measurement of income used specifically for these purposes. Provisional income is calculated as your total income from taxable sources (essentially the net amounts included on the front page of your tax return in calculating Adjusted Gross Income), plus any tax-exempt interest (i.e., from municipal bonds) and excluded foreign income, plus one half of your Social Security benefits. If this total exceeds $25,000 for individuals ($32,000 for married couples), then 50% of the excess is the amount of Social Security benefits that must be included in income. If provisional income exceeds $34,000 for individuals ($44,000 for married couples), then 85% of the excess amount is included in income. (Notably, if provisional income exceeds the 85% threshold amount, it must have already surpassed the 50% threshold amount, and there are some additional calculations to coordinate between the two, until a maximum of 85% of all Social Security benefits become taxable.) Some examples may help to illustrate:
Jeremy and Martha have an AGI of $28,000 (and no tax-exempt or foreign income), and receive combined Social Security benefits of $14,000. As a result, their provisional income is $28,000 + $7,000 (half of Social Security benefits) = $35,000, which is $3,000 above the $32,000 threshold. This means that 50% x $3,000 = $1,500 of their Social Security benefits are subject to taxation, which ultimately increases their AGI to $28,000 + $1,500 = $29,500.
Donald and Sarah have an AGI of $44,000 and receive combined Social Security benefits of $24,000. As a result, their provisional income is $44,000 + $12,000 = $56,000, which is $12,000 above the upper $44,000 threshold. This means that $16,200 of benefits are subject to taxation (which is technically 50% of the amount from $32,000 to $44,000 plus 85% of the excess above $44,000), which ultimately increases their AGI to $44,000 + $16,200 = $60,200.
Paul and Megan have an AGI of $58,000 and receive combined Social Security benefits of $24,000. As a result, their provisional income is $58,000 + $12,000 = $70,000, which is $26,000 above the upper $44,000 threshold. This means that $20,400 of benefits are subject to taxation (which is the maximum 85% of the $26,000 excess above the upper threshold, capped out at 85% of their total Social Security benefits), which ultimately increases their AGI to $58,000 + $20,400 = $78,400.
The bottom line: as income rises, more Social Security benefits are subject to taxation, until eventually a maximum of 85% of all benefits are included in income for tax purposes!
Taxation Of Social Security As A Marginal Tax
Because the formulas to determine the amount of Social Security benefits to include in income are themselves based on income, the net result is that the inclusion of Social Security functions like a surtax on income while it is phasing in. And because of the high percentage of Social Security benefits that become taxable as income rises, the effect can be significant.
Continuing the earlier example of Jeremy and Martha, if the couple decides to take another $1,000 out of their IRA, this will increase their AGI by $1,000 to $29,000. As a result, it will also increase their provisional income by $1,000, which leaves them $4,000 above the threshold, resulting in $2,000 of their Social Security benefits being taxable. In the end, this means Jeremy and Martha end out with a total AGI of $31,000... their AGI increased by $1,500 even though they only took out a $1,000 IRA withdrawal due to the taxation of Social Security benefits! If the couple is subject to the 15% tax bracket, their additional tax liability on $1,500 of income is $225, which equates to a marginal tax rate of $225 (additional taxes) / $1,000 (additional income) = 22.5%. In other words, even though the couple is in the 15% tax bracket, their $1,000 IRA withdrawal is subject to a 22.5% marginal tax rate due to the formulas triggering taxation of Social Security benefits!
Continuing the earlier example of Donald and Sarah, if they decide to take out another $1,000 from their IRA, their provisional income will rise to $57,000, and another $1,000 x 85% = $850 of Social Security benefits will be subject to taxation. This increases their AGI by $1,850, which leads to $277.50 of additional taxes. The end result: Donald and Sarah face a $277.50 / $1,000 = 27.75% marginal tax rate even though they're in "just" the 15% tax bracket, due to their greater income triggering taxation of additional Social Security benefits at 85 cents on the dollar!
Continuing the earlier example of Paul and Megan, if they decide to take out another $1,000 from their IRA, their provisional income will increase to $71,000. However, since they are already capped at 85% of their maximum Social Security benefits being subject to taxation, their AGI simply increases to $59,000 + $20,400 = $79,400. In other words, because the maximum amount of Social Security benefits were already subject to taxation, another $1,000 of income simply increases their AGI by... $1,000! Assuming the couple is subject to the 15% tax bracket (which they should be after personal exemptions and itemized deductions), the additional taxes on $1,000 of income will be $150, which means their 15% tax bracket really does mean a 15% marginal tax rate!
Notably, the net result of these formulas is that while 50% of Social Security benefits are being phased in, the marginal tax rate is essentially boosted by 50%, from 15% to 22.5%. For those whose income exceeds the upper threshold, the marginal tax rate is boosted by extra 85%, from 15% to 27.75%! This essentially results in a tax bracket "bubble" that occurs as Social Security benefits are being phased in, until the maximum phase-in is reached and the client's tax rate returns his/her normal tax bracket again.
For individual clients, the effect can be even more severe, because the taxation of Social Security benefits potentially overlaps not just the 15% tax bracket, but the 25% tax bracket (which starts at "only" $36,250 for individuals). As a result, individual clients face a potential tax rate boost from 25% to 46.25%!
Harry is an individual with $36,000 of income but a hefty $22,000/year of Social Security benefits. His Social Security provisional income is $36,000 + $11,000 = $47,000, which is $13,000 over the upper threshold for individuals. As a result, $15,550 of his Social Security benefits are subject to taxation (which is 50% of the amount from $25,000 to $34,000, plus 85% of the excess of provisional income above the $34,000 threshold), which puts his AGI at $51,550. Even after a standard deduction and one personal exemption, Harry's taxable income would be $51,550 - $6,100 - $3,900 = $41,550, which places him in the 25% tax bracket.
If Harry now takes an additional $1,000 from his IRA, his provisional income increases to $48,000, his taxable Social Security benefits increase to $16,400, and his AGI rises to $53,400. The net result: Harry's AGI increased by $1,850 for "just" a $1,000 IRA withdrawal, and with a 25% tax bracket his liability will be $1,850 x 25% = $462.50, which equates to a whopping $462.50 / $1,000 = 46.25% marginal tax rate!
In practice, it takes a unique combination of income and Social Security benefits to face this 46.25% marginal tax rate, although it is possible; due to how the tax brackets line up with the Social Security taxability thresholds, it's more common for individuals than married couples (the latter generally don't see this 46.25% marginal tax rate unless they are slowly phasing in a very large pool of combined Social Security benefits). And because the tax brackets are indexed for inflation while Social Security benefits are not, the overlap of 85% Social Security benefits inclusion and the 25% tax bracket is actually declining over time (as the 10% and 15% brackets widen slightly each year). Nonetheless, the fact remains that the phase-in of Social Security benefits can result in surprisingly high marginal tax rates for clients with relatively "modest" income levels - as even a 15% tax bracket can be boosted up to 27.75%!
Planning Around The Taxation Of Social Security Benefits
Planning strategies should be done based on marginal tax rates, which means the leaps in marginal tax rates from including Social Security benefits can and should be a material factor in planning - especially since the rates have the greatest impact on those whose income is relatively modest and may not realize they are exposed to 27.75% (or even 46.25%!) marginal tax rates when they "thought" they were in just the 15% or 25% tax brackets.
For many clients, though, the rates are at least partially unavoidable. In many situations, there simply is not enough income flexibility to spread income out to stay below the thresholds. Although notably, for some clients, the best thing to do is to actually accelerate income and lump it together; after all, additional income beyond the point that the maximum 85% of Social Security benefits are taxable is subject to only a 15% (or 25%) tax bracket, which is far better than leaving the income until next year when it may be taxed at 27.75% (or 46.25%) due to the phase-in of Social Security benefits. In fact, in some cases it might even be worthwhile to trigger a bit of additional Social Security benefits taxation just to reach the cap and then add more income beyond it at a current tax bracket!
In other situations, the best thing to do may be managing income earlier to avoid exposure in the later years. For instance, Roth conversions before a client starts Social Security benefits can leave a more flexible pool of money to draw upon in the later years - not to mention avoiding RMDs - allowing the client to avoid 22.5%, 27.75%, or 46.25% marginal tax rates down the road. Of course, the caveat for Roth conversions is still not to do too much at once, driving up the current tax rate to an untenable level, as the primary benefit of Roth conversions is still to do them when current rates are lower than future rates! Nonetheless, if the reality is that future tax rates will be 22.5%, 27.75%, or greater, then doing partial Roth conversions to fill the lower tax brackets now to avoid those higher marginal rates in the future is certainly a good deal. And alternatively, some clients who currently face these rates might still do partial Roth conversions getting through the taxability of Social Security benefits, so they can do additional Roth conversions that year above the Social Security taxability cap at favorable tax rates to further reduce exposure down the road.
Tax deferral strategies can also be appealing to manage Social-Security-triggered higher marginal tax rates. This might not only include just continuing to maintain and stretch tax-deferred IRAs (to the extent they're not converted), but also the use of non-qualified fixed or variable annuities to defer income; while tax-deferral doesn't eliminate exposure to the effect entirely, it's nonetheless true that tax deferral itself is worth a whole lot more when the client's marginal tax rate is so high! Similarly, effective asset location strategies to shelter the most high-income tax-inefficient assets also become more important where client marginal tax rates are so high.
On the other hand, it's notable that strategies like investing in tax-free income to avoid high Social-Security-taxation marginal rates does not work, since municipal bond income is itself included in provisional income! The end result is that while the bonds themselves still wouldn't be taxable, they would still face a 7.5% - 12.75% marginal tax rate (for those in the 15% tax bracket) as 50% or 85% of Social Security benefits become subject to taxation. Similarly, the impact can also boost the marginal tax rate for capital gains, which may enjoy a 0% tax rate for those in the bottom tax brackets, but nonetheless increase AGI and provisional income and therefore indirectly trigger the taxation of Social Security benefits.
Unfortunately, the reality is that no two clients will be exactly the same for their exposure to higher marginal tax rates from the taxability of Social Security benefits, because the exact scope varies depending on both the nature of their taxable income and the total amount of their Social Security benefits that may be subject to taxation in the first place. For some clients with smaller benefit payments, the impact is fairly limited; for others with a very large pool of payments, the effect can continue over a much wider range of income and spanning across not just the 15% tax bracket (with 27.75% marginal rates) but the 25% bracket (with 46.25% marginal rates). Ultimately, all clients will cap their exposure when the maximum 85% of Social Security benefits are being taxed, but the exact level of this cap itself will vary depending on the amount of Social Security being received. Which means in the end, the analysis must be done on a client by client basis... but with potential 46.25% marginal tax rates, it's worth the effort!