Taxation of Social Security Retirement Benefits: What You Need To Know

Social Security Taxation: What You Need to Know

*The following is for informational and educational purposes only and should not be considered professional or personal tax advice.

Many retirees count on their Social Security retirement benefits as making up a sizeable portion of their income in retirement. Due to this fact, much attention has been given to maximizing distribution strategies by determining the appropriate timing to take these benefits; however, much less attention is given to how this benefit interacts with other income you may receive in retirement and the implications of this on yearly taxes. The truth is that social security taxation is a bit complex and depends on several factors. This article will seek to break this down for you and help you understand more clearly how this may be relevant to your financial plan.

How is Social Security Taxed?

Many people, including retirees, do not understand the taxation of social security and what it may mean for their financial plan. Understanding how social security is taxed can be important when making financial planning decisions, particularly around distribution strategies for your portfolio in retirement.

The first step in understanding the taxability of your Social Security benefits is to calculate your provisional income. This is a combination of your modified gross income and half of your gross annual Social Security retirement benefit. By understanding this process, you can gain a clearer picture of how your Social Security benefits may be taxed, empowering you to make more informed financial decisions.

What is modified adjusted gross income (MAGI)?

Modified adjusted gross income refers to taking your gross income and adding back in tax-exempt interest (such as municipal bond interest). For example, gross income includes all pension income, traditional IRA distributions, interest, dividends, or other rental income. To arrive at MAGI, you would simply add tax-exempt interest to this figure to know the result.

Several other categories may need to be added back into the calculation of MAGI (but these are less common), including interest earned on savings bonds with education, interest earned in a foreign country, amount deducted for interest paid on loans for education, and amounts excluded from income related to employer-assisted adoption assistance (Dalton, J.F.D.M. A., 2023).

How to arrive at provisional income

Provisional income is simply equal to MAGI + ½ gross social security. This is why it is essential to calculate MAGI as a first step in this process.

Filing status and taxability of Social Security

The IRS has set provisional income thresholds subject to different taxation rules concerning social security benefits. For example, in 2024, if you are a single filer and your provision income is less than $25,000, then none of your social security is taxable. The same is true for a married couple filing jointly with a provisional income of less than $32,000. These thresholds do not change on a year-to-year basis or inflate. Meanwhile, social security is subject to cost-of-living increases, which means that with each passing year, more and more social security benefits will likely be taxable for the average retiree. To illustrate the brackets of provisional income and the taxation of social security, see the table below.

Provision income Brackets	Married Filing Jointly	Single Filers	Percent of social security that is taxable
Income Tier 1	$0-$31,999	$0-$24,999	0
Income Tier 2	$32,000	$25,000	Income between these two will cause SS to be taxed at 50%
Income Tier 3	$44,000	$34,000
Income Tier 4	>$44,000	>$34,000	Income greater than this will cause up to 85% of SS to be taxed *The most that you can be included in taxable income is 85% of the total social security benefit

How to calculate the amount of social security that is taxable from MAGI?

Example: John and Sue have $30,000 of gross income from a pension and $4000 of municipal bond interest earned in 2024. They have a gross social security amount of $40,000 ($20,000 each) and a designated tax filing status of married filing jointly.

1. Determine MAGI = $30,000 + $4,000 = $34,000
2. Determine provisional income = MAGI + ½ gross social security = $34,000 + $20,000 = $54,000
3. Determine the taxable amount of social security benefits based on Tier

First $32,000 = 0% taxable

Next $12,000 (between $32,000-$44,000) = 50% taxable = $6,000

Next $10,000 (between $44,000-$54,000) = 85% taxable = $8,500

Total taxable social security = $14,500

*Note that this calculation is similar to how our federal income tax on income is calculated. This couple did not have 85% of their benefit subject to taxation, but only a small portion was taxed at this rate. The maximum allowable amount included as taxable is 85% of the gross social security amount.

What about state taxation of social security?

Each state has its own regulations on how or if social security is taxed. In South Carolina, there is no state taxation of Social Security retirement benefits.

Why does this matter?

There are several reasons that this is important for you to understand in retirement.

1. The first reason is that grasping how your social security benefit impacts your taxable income can inform your strategy for taking distributions from your accounts in retirement.

To illustrate this point above, we will continue with the previous example of the couple in retirement:

Income subject to taxation would be $30,000 + $14,500 (taxable portion of social security) = $44,500.

Take into account standard deduction = $44,500- $29,200 = $15,300 taxable income (10% federal tax bracket)

In 2024, those married filing jointly with taxable income below $94,050 pay 0% on long-term capital gains distributions.

If this couple has a large appreciated stock or capital gains sitting in a non-qualified account, this would be a great year to take a large portion of this out to fill up the 0% capital gains bracket and create tax-free money to be used in the current year (for a goal or need) or to invest in an after-tax vehicle that could earn a return with no risk (such as a CD or high yield savings account) if they had other short term liquidity needs upcoming. This strategy is one scenario where knowing your tax liability ahead of time can help you make the appropriate distribution decision. In this case, taking more money from a traditional IRA would not be optimal and would squander the favorable tax opportunity. This also highlights the benefits of having several “buckets†of retirement savings such as: tax-deferred qualified, non-qualified, and Roth.

• The second reason that this is important to understand is that it can help you understand more fully the benefit of delaying social security and better inform your decision on if converting traditional IRA money to Roth IRA money makes sense.

Consider the example above where the couple finds themselves in the 10% federal marginal tax bracket after applying the standard deduction. It is reasonable to assume that this means that for every additional $1000 dollars that are earned, the tax liability will be 10% of this; however, due to the impact of social security being predicated on other income this is not the case.

Previously, the couple had $30,000 of income and $14,500 of taxable social security income. If they chose to pull an extra $1000 from a traditional IRA that year, then:

Income = $31,000 + $14,500 = $45,500

The extra $1000 dollars would be taxed at the 85% rate for social security, or said another way, this would be a total increase in taxable income of $1850.

Because they are in the 10% tax bracket, the total tax incurred on the $1000 of extra income = $1850 * .10 =$185, so $185/$1000 = 18.5% marginal tax rate

This is often referred to as the tax torpedo, and it will disproportionately affect most middle-income retirees. The example above is mild, but the marginal rate can be much higher for single filers and potentially could be higher in the future depending on what tax brackets look like in 2026 and beyond. This tax effect does level off once provisional income levels are high enough that 85% of the total social security benefit amount is included in taxable income.

With the uncertainty around future tax brackets potentially increasing back to pre-2017 levels, this phenomenon is one to watch to ensure that you are mitigating taxes in retirement. This knowledge can also help you make a more informed decision on if you should be contributing to a Roth account today (or converting pre-tax money to Roth). We cannot control the future of tax rates, but understanding what your income sources may be in retirement can be useful in planning these strategies. Knowledge of how social security is taxed also helps to strengthen the case for delaying social security until 70 when possible. The tax torpedo above illustrates this point, and if you can delay your social security in most cases, it can end up saving you in taxes over the long term. Suppose you have a modest amount of gross income in retirement apart from social security. In that case, it may be best in many cases to delay drawing so you will not increase your marginal tax bracket based on provisional income. This strategy also gives you time to convert money to Roth when appropriate, so you will not be taking large RMDs that would drive up your provisional income when you eventually decide to take your social security benefits.

Conclusion

The article above highlights the nature of social security taxation and why it is crucial when considering planning decisions in the future and in the here and now. Every situation is unique, and we at Brightworks are here to assess each situation to craft the most advantageous plan for you to meet your goals.

Dalton, J.F.D.M. A. (2023). Retirement Planning & Employee Benefits (19th ed.). Money Education. https://online.vitalsource.com/books/9781957511016