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Taxation of Social Security Benefits

When and how does Social Security get taxed? The computation is complicated. In fact, the IRS has a special worksheet just for that purpose. The Motley Fool website explains the rules as follows: The math starts with your Adjusted Gross Income. To that you add one-half of all Social Security benefits and all of the otherwise non-taxable unearned income received during the year but not included in AGI (tax free interest, etc.) If the computed total is larger than $25,000 (single) or $32,000 (married filing jointly), then up to 50% will be taxed. If the amount is larger than $34,000 (single) or $44,000 (married filing jointly), then up to 85% will be taxed. To determine the exact amount that will be taxed, you must complete the worksheet supplied by the IRS for that purpose, but the following examples may help.

Married Couple within first threshold:
Pensions & Taxable Investments$29,500
Municipal Bond Interest$ 2,000
Social Security Benefits$14,000

In this scenario, the preliminary Adjusted Gross Income (AGI) consists of the pension and the taxable investment income, or $29,500. To that number, they must now add all of their tax-free municipal bond interest ($2,000) and one-half of their Social Security benefits ($7,000). The resulting sum determines if any of the Social Security benefits will be taxed, and it will give them their Modified Adjusted Gross Income for the Social Security taxation test. If the sum exceeds either the $32,000 or the $44,000 threshold, then part of the Social Security will be taxed. Here's how it works:

Preliminary Adjusted Gross Income$29,500
Tax-free municipal bond interest2,000
50% of Social Security benefits7,000
Modified Adjusted Gross Income$38,500
Less first threshold amount32,000
Excess over first threshold$6,500

This couple has exceeded the first test threshold (but not the second), so now they must determine what part of the Social Security benefit will get taxed as ordinary income. That amount is the smaller of (i) one-half of the excess determined above, or (ii) or one-half of the Social Security benefit received during the year.

One-half of the excess is $3,250 ($6,500 divided by 2).
One-half of the benefit is $7,000 ($14,000 divided by 2).
$3,250 is smaller than $7,000, so $3,250 is added to their taxable income.
That brings their AGI to a total of $32,750 ($29,500 plus $3,250).

Married Couple within the second threshold: (assume IRA distributions required after age 70.5 now add another $10,000 of taxable income)

Preliminary Adjusted Gross Income$39,500
Tax-free municipal bond interest$ 2,000
50% of Social Security benefits$ 7,000
Modified Adjusted Gross Income$48,500

Excess over the first threshold ($48,500 - $32,000)$16,500
Excess over the second threshold ($48,500 - $44,000)$ 4,500

In this instance, the couple must determine the smaller of:

a.50% of the excess over the $32,000 threshold
plus 35% of the excess over the $44,000 threshold
[($16,500 x 0.5) + ($4,500 x 0.35)]
$ 9,825

b.85% of the Social Security benefit ($14,000 x 0.85)$11,900

c.50% of the Social Security benefit plus 85%
of the excess over the $44,000 threshold
[($14,000 x 0.5) + ($4,500 x 0.85)]

The smallest of those three computations, or $9,825, is added to the preliminary AGI of $39,500 to bring their AGI to $49,325

Estimated income taxes are not withheld from Social Security payments unless the recipient has submitted Form W-4V (Voluntary Withholding Request) to the Social Security Administration (SSA) for that purpose. In the absence of that action, we are responsible for those payments, and unless we meet one of the limited safe harbor tests for not making those payments quarterly, then failure to do so will result in a penalty on top of the taxes due at tax-filing time.