When it comes to income tax, a lot changes when you retire. Your money is not coming from a paycheck anymore. Social Security is the baseline of many retirees’ income. It is important to know how this benefit will be taxed in order to accurately plan for your retirement.
Income Tax: Social Security
State Income Taxes on Social Security
Currently, only 13 states tax Social Security. These states are Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont, and West Virginia. West Virginia is phasing out tax on Social Security in 2022 and will join the other 37 states that do not tax your benefit.
Each of the 13 states tax Social Security differently. Most have income thresholds that they base their taxes on. If you are in one of these states, consult a financial professional who specializes in Social Security.
Federal Taxes on Social Security
When it comes to federal income taxes on Social Security, everybody is at the same starting point. Your Social Security check starts tax free. If it makes up all of your income, you will not pay any federal income tax. Your other taxable income is what will cause taxes to kick in.
What counts as taxable income for Social Security?
Taxable income is the portion of your money that is used to calculate how much tax you owe. Interest, pensions, IRA and 401(k) withdrawals, dividends, capital gains, salaries, and wages are all types of taxable income.
Roth IRA withdrawals, savings account withdrawals, deferred interest within annuities and life insurance, and loans from life insurance policies are nontaxable.
Basically, any money you have not paid taxes on previously is going to count as taxable income while any money you have already paid taxes on is not.
What if I work while collecting Social Security?
There is nothing to prevent you from working and collecting Social Security, but it could majorly affect the amount of money you get to keep. If you take Social Security before your Full Retirement Age (FRA), you will be subject to income limits.
Full Retirement Age is going to be based on your birthday. While it used to be 65, it is now between 66-67.
If you take Social Security before your FRA and earn more than $18,240 per year in 2020, you will lose some of your benefit. Social Security will deduct $1 for every $2 you make over $18,240. Once you reach your full retirement age, your benefit will be recalculated to account for the months benefits were withheld.
These deductions are a little different if you hit your FRA part way through the year.
Once you hit your full retirement age, you will not have any money deducted from your Social Security benefit. You could still pay taxes on the benefit though if you have other taxable income.
Calculating Combined Income for Social Security
“Combined Income” refers to the portion of your Social Security benefit that is subject to federal income tax. The formula for calculating combined income is:
(½ of your Social Security check) + (your other taxable income) = combined income.
This number is going to determine if and how much your Social Security benefit will be taxed.
If you are single and make over $25,000 in combined income, you will pay federal income tax on your Social Security. For married people, it is $32,000.
If you exceed this threshold, you will pay taxes on a portion of your check, up to 85%.
If you know you are going to continue working through retirement, there are strategies you can put into place now to possibly lower this other income.
Example of lowering combined income
We have a client, Ellen, who wanted to retire without having her Social Security check taxed. The benefit she receives is $1,500/month. She also has a 401(k), which would count as taxable income when she pulled the money out of the account.
We helped her roll her 401(k) into an annuity that pays her $1,000 a month for the rest of her life. She also inherited some money, which we used to completely pay off her house and buy a new car, things that would lower her monthly bills. This means, when she retired, she was bringing in $2,500 monthly.
We took half of her yearly Social Security check, $9,000, and added that to the $12,000 she was getting from the annuity, her combined income is $21,000. She falls under the $25,000 threshold for a single person. She does have some interest on her money in savings, but that is at most a few $100, which would not put her over the limit.
In addition to all this, Ellen also has $200,000 growing in deferred annuities. With her house and car paid off,emergency savings, and her growing annuity, $2,500 monthly is more than enough for Ellen to live off of, especially since it is tax-free.
If you only plan to live off of your Social Security check in retirement, you will not have to pay taxes. If you have other taxable income you will be using, you will need to plan for this. While it is not advisable to base your entire retirement income strategy around eliminating taxes on Social Security, it can lead to a more tax-efficient retirement. Cardinal can help you find the best solution for your taxes and Social Security benefit.