Taxation of Social Security Benefits

In a comment to April 27’s post, David raised a question about the taxation of social security benefits. Actually, David touched on a number of issues, for which I am grateful as it provides fodder for future blog posts. But for today, it’s Social Security.

When you start receiving Social Security benefits, are they subject to federal income tax? Not totally. Here’s the story.

For many years social security benefits were totally tax-free. That was a great deal, but it didn’t last. In the early 80’s, as part of an effort to ensure the long-term solvency of the Social Security system, Congress decided to subject part of your benefits to income taxation. (That worked well, didn’t it?) Someone in the government actually keeps track of this little slice of our income tax revenue, and transfers that amount from the general coffers into the Social Security trust fund. But that doesn’t affect us individually, so let’s move on.

When Congress resolved to tax Social Security benefits, they didn’t go all the way. The thinking was this. Part of your benefit is funded with your share of FICA taxes; you know, that’s the 6.2% tax on the first $106,800 (in 2009) of your salary. But you already paid income tax on that amount during your working years; unlike a traditional 401(k) elective deferral, your Social Security contribution is not deducted when figuring your taxable income. So to tax that amount again when you start receiving benefits would be to tax the same compensation dollars twice. That doesn’t sit well, does it?

To avoid an unfair double-tax, Congress decided to limit the amount of your benefit that’s subject to income tax to no more than 85%. Where did that figure come from? On average, the remainder, 15% of your benefit, is the portion of your benefit that’s funded by your own FICA contributions. The other 85% is funded by your employer’s half of the FICA tax and by investment earnings within the trust fund over your working life. Neither of those components has ever been subjected to income tax, so in that sense it’s fair to do so when you begin receiving benefits.

Congress wisely decided not to try to keep track of your actual tax basis in your Social Security benefit, as you have to do when you make after-tax contributions to a traditional IRA. The 85% number achieves rough justice, so it was deemed good enough.

But that’s not the whole picture. It gets complicated. So as not to over-burden low income people during their golden years, the Tax Code excludes Social Security benefits from the taxable income of low income people; and middle income people are only subjected to tax on 50% rather than 85% of their benefits. Only higher income people are subjected to tax on the maximum 85% of their benefits.

The process for figuring out what portion of your Social Security benefit is taxable (0%, 50% or 85%) is complicated beyond all human understanding. You can find a worksheet for figuring this out in the instructions for the Form 1040. Or just plug in your numbers and let Turbo-Tax do it.

But these three levels of taxation carry an impact of which you should be aware. To avoid an abrupt spike in your income tax when you move from 0% to 50% or from 50% to 85%, the Tax Code creates phase-out ranges. If your particular income tax picture puts you in one of these ranges, your actual—but hidden—tax bracket is much higher than your nominal tax bracket. Maybe one-and-a-half times as big. Which is ironic, since it has the effect of subjecting low income people to a high tax rate.

Another side effect of these phase-out ranges carries an implication for the taxation of municipal bond interest. Interest on state and local bonds is generally exempt from federal income taxation. But it’s nonetheless counted for purposes of determining the percentage of your Social Security benefits that’s taxed. So if you’re in one of the phase-out ranges, in effect municipal bond interest is taxable. But it’s a hidden tax. Nothing's easy, is it?

The good news in all this is that if your taxable income is over a certain threshold, all the complexity melts away, and a flat 85% of your benefits is taxed. No, wait. That’s bad news!