Taxes and Social Security Benefits
The taxation of Social Security benefits is a complicated issue. Including tax issues into our analysis of optimal retirement ages multiplies those complications. Here we discuss some basic issues concerning the taxation of Social Security benefits and how that taxation might affect your claiming decision. We first provide an overview of the issues. Then, for those interested in more detail, we go into greater depth later in this section. Also, for a comprehensive discussion of the matter, you should see the IRS Publication 915. Further, we focus only on the federal income tax. In a minority of the states, Social Security benefits are also subjected to state income taxation. (See State Taxation of Social Security Benefits below for some the details.)
Before proceeding, let us be clear about an important matter. We are not asking you to provide any confidential personal data, including tax information. So, in our computations, taxes are left out of the picture. But, we can offer some insight as to how taxes might affect your decision about when to claim your benefits. As we will see, taxes on Social Security often have no impact on when you should claim your benefits. Tax issues will generally affect your claiming decision only when you anticipate a significant future reduction in your tax bracket.
First, lower income earners pay no federal income taxes on Social Security benefits, so taxation is not an issue for them. However, once a relatively low threshold level of taxable income is surpassed, somewhere between 50 to 85 percent of benefits are subject to taxation. (For additional information, see Fraction of Benefits Taxed at the Federal Level below.)
Next, you would need to consider the tax rates that may apply to your situation. Presently, there are seven tax brackets, or marginal tax rates: 10 percent, 15 percent, 25 percent, 28 percent, 33 percent, 35 percent, and 39.6 percent. About 75 to 80 percent of taxpayers fall into the bottom three tax brackets, so we focus our attention on those marginal rates. (For more detail, see Federal Income Tax Brackets for 2013 below.)
To illustrate how the marginal tax brackets work, let's suppose Anna starts receiving $20,000 a year in Social Security benefits at age 62. Anna is in the 25 percent tax bracket, and this additional income does not push her into the next higher tax bracket. Assuming that 85 percent of her benefits are taxable, she would pay 25 percent of $17,000 in taxes, or $4,250. At age 64, Anna's tax rate falls to 15 percent (perhaps because of a drop in other taxable income). At that point, the taxes on her Social Security benefits would drop to $2,550 (15 percent of $17,000, again assuming that 85 percent of her benefits are taxed.)
So, how does this affect the decision as to when to start your benefits? In part, the answer depends on the following two things. The first is whether you anticipate a tax rate change at some after your tentative optimal claiming year. If no tax rate change is anticipated, then the tax issue is irrelevant for this calculation. In order to change the optimal claiming age, anticipated tax rates must change at some point in the future.
The second crucial item is whether you anticipate a change in the fraction of Social Security benefits that are taxed. It is possible for a drop in taxable income to lower the fraction of Social Security benefits taxed, even though the marginal tax rate remains unchanged. For example, assume that Ken currently has $10,000 in annual Social Security benefits, with 85 percent of those benefits taxed at a marginal rate of 15 percent. The tax bill on his Social Security benefits is $1,275 (= $10,000×0.85×0.15). Next year, Joe's income falls enough to reduce the share of benefits taxed to 50 percent, without reducing his marginal tax rate. His tax bill falls to $750 (= $10,000×0.5×0.15). If there is no anticipated change in the share of benefits taxed (and the tax rate remains unchanged), then again the tax issue is irrelevant.
We provide an illustration of how taxation might affect the optimal claiming age in Table 1 below. The results shown in this table are based on the assumptions 1) that 85 percent of benefits are taxed; 2) that only a single individual is involved; and 3) that the individual receives $2,000 a month in pre-tax Social Security benefits.
Table 1 shows the optimal claiming age under various scenarios. It considers four different possible life expectancies, from age 75 to age 90. It also allows for some selected possible changes in marginal tax rates that a Social Security claimant might face, including no change at all. For example, a "5 percent reduction" would occur if a person's income fell enough to move them from a 15 percent marginal tax bracket to a 10 percent tax bracket. Likewise, a "10 percent reduction" would occur if a person went from a 25 percent tax bracket to a 15 percent tax bracket.
|Life Expectancy||No Change||5% Reduction||10% Reduction||15% Reduction|
For each of the life expectancies, we assume that the tax rate reduction occurs at some age greater than the optimal claiming age shown in the above table in the "No Change" column (that is, when there in no tax rate change). For instance, for the 75-year life expectancy (the first row of data), we assume that any tax rate reduction occurs at age 63 or later. Likewise, for the 85-year life expectancy, we assume that any tax rate reduction occurs after age 68. If a tax rate reduction occurred at age 67 or earlier, it would have no affect on the optimal claiming age.
Our analysis of the tax issue reveals the following important point. A future tax bracket reduction has its biggest impact when the change occurs immediately after the optimal claiming year. The impact diminishes as the tax bracket change moves further away from the optimal claiming year. To illustrate, look at the third row of numbers in the above table (for an 85 year old person). If a tax rate reduction occurs at age 69 without affecting the optimal claiming age, then that same reduction at age 70 or later would, likewise, have no impact on the optimal claiming year. In contrast, suppose a tax rate reduction at age 70 shifts the optimal claiming age from 69 to 70. That same tax rate reduction at age 71 or even later might also increase the optimal claiming year to age 70. But, the impact of a tax rate reduction diminishes as the time between the (no-tax change) optimal claiming year and the tax-cut year increases. For example, suppose a substantial tax rate reduction at age 72 or 73 shifts the claiming year from 69 to 70. The same tax rate reduction at age 80 would have no impact on the optimal claiming year. Such a change is too far into the future to matter.
Fraction of Benefits Taxed at the Federal Level
How much of your Social Security benefit is taxable? For those with relatively low incomes, none of the Social Security benefit is taxable. However, as income increases, somewhere between 50 to 85 percent of benefits are taxable. You can do some quick computations to determine whether some of your benefits may be taxable:
- First, add one-half of the total social security you received to all your other income, including any tax exempt interest and other exclusions from income.
- Then, compare this total to the base amount for your filing status. If the total is more than your base amount, some of your benefits may be taxable.
The 2013 base amounts are:
- $32,000 for married couples filing jointly
- $25,000 for single, head of household, qualifying widow/widower with a dependent child, or married individuals filing separately who did not live with their spouses at any time during the year.
So, for a married couple with an income (adjusted as described above) less than $32,000, none of their Social Security benefits are taxable at the federal level. In the income range $32,000 to $44,000, between 50 to 85 percent of Social Security benefits may be taxable at the appropriate marginal tax rate. Above $44,000 in adjusted income, 85 percent of benefits may be taxable. To determine the exact amount that is taxable, you should complete the IRS worksheet in IRS Publication 915.
For the next category (singles, head of household, etc.), those with adjusted incomes less than $25,000 would pay no taxes on their Social Security benefits. Between $25,000 and $34,000, somewhere between 50 to 85 percent of Social Security benefits may be taxable at the appropriate marginal tax rate. Above $34,000 in adjusted income, 85 percent of benefits may be taxable. Again, see IRS Publication 915 for further details.
Federal Income Tax Brackets For 2013
The table below shows federal marginal tax brackets for 2013.
|Tax Rate||Taxable Income Range for Married Couples Filing Jointly||Taxable Income Range for Most Single Filers|
|10%||Not over $17,850||Not over $8,925|
|15%||$17,850 - $72,500||$8,925 - $36,250|
|25%||$72,500 - $146,400||$36,250 - $87,850|
|28%||$146,400 - $223,050||$87,850 - $183,250|
|33%||$223,050 - $398,350||$183,250 - $398,350|
|35%||$398,350 - $450,000||$398,350 - $400,000|
|39.6%||Over $450,000||Over $400,000|
Based on IRS data, among married tax filers (filing jointly), about 75 percent are in the bottom 3 tax brackets. Among single filers, about 80 percent are in the bottom 3 brackets. The brackets are large, so individuals may experience a substantial income drop without any change in tax brackets. For those that do shift brackets, the change will generally be 5 percent or 10 percent (although it is certainly possible that a few tax payers could experience a 25 or even 35 percent change).
State Taxation of Social Security Benefits
Presently, 14 states with broad-based income taxes tax Social Security to some extent:
- Minnesota, Nebraska, North Dakota, Rhode Island, Vermont and West Virginia generally tax Social Security income to the extent it is taxed by the federal government.
- Connecticut, Iowa, Kansas, Missouri and Montana generally tax a smaller fraction of Social Security income than does the federal government. Iowa will gradually phase out its Social Security tax levy from 2008 through 2014. Missouri plans to phase out its Social Security tax levy by 2012. Kansas residents can exclude Social Security income if their adjusted gross income is less than $75,000.
- Colorado, New Mexico and Utah require that federally untaxed Social Security benefits be added back to federal AGI to calculate the base against which their broad age-determined income exclusions apply.
The 2012 minimum and maximum marginal tax rates for the states that tax Social Security benefits to some extent are shown in the following table.
|State||Minimum Marginal Tax Rate||Maximum Marginal Tax Rate|
If you live in one of these states and you want more information about your state's marginal tax brackets or tax treatment of Social Security benefits, go to the state's Department of Revenue website.