Understanding Social Security benefits can be challenging.
When should I start taking them? How will taxes, if any, be taken out? Will I be penalized for continuing to work? Even if taxpayers are nowhere near the age to start taking distributions, everyone must pay into the system. One day, hopefully, everyone who paid into the system for their entire career will get some or most of their money back.
RULE 1. A taxpayer must include Social Security benefits in income when provisional income exceeds a specified amount.
What is provisional income? One-half of all Social Security Income plus ALL other income, including tax-exempt interest.
A taxpayer cannot exclude income received from interest from U.S. Savings bonds, employer-provided adoption benefits, foreign-earned income, foreign housing, or income earned as a resident of American Samoa or Puerto Rico.
Rule 2. The percentage of Social Security benefits, which must be included in income, is zero when provisional income is below the lower base amount in the chart below. Only to 50% when provisional income exceeds the lower base amount and can be as high as 85% when provisional income is above the upper base amount.
The threshold to determine the maximum percentage of benefits subject to tax.
EXAMPLE: A married taxpayer receives $25,000 in social security benefits. The taxpayer has $15,000 in tax-free municipal bond interest and $40,000 in taxable IRA withdrawals during the year.
Determine provisional income as follows:
The provisional income of $50,000 exceeds the upper threshold for Married Filing Jointly status. For this taxpayer, the taxable portion of social security benefits to include in income can be as high as 85% of benefits, or $17,000 ($20,000 social security benefits × 85%).
RULE 3. Allocate provisional income based on filing status. Multiply the amount of provisional income between the lower and upper base amounts by 50% and the amount above the upper base amount by 85%, and then add the two together. The taxable portion of social security benefits to include in income is the lower of this amount.