A closer look at the provisional income rules.
Many new retirees assume that Social Security income is tax-free. That is not always the case. The Social Security Amendments of 1983 opened the door to taxes on some SSI, depending on the amount of income someone earns in a calendar year.
How much of your SSI is potentially taxable? As much as 85% of it, under certain conditions. Four factors determine how much of your SSI will be taxed:
â€¢ The total amount of income that you earn.
â€¢ Where it comes from.
â€¢ Your taxpayer filing status.
â€¢ Your provisional income â€“ a MAGI calculation which you can figure out by using Worksheet 34-1 in IRS Publication 915 or the Social Security Benefits Worksheet in the instruction booklets for IRS Form 1040 and Form 1040A.
How is provisional income determined? In simple terms, this is calculated using your AGI, minus one-half of your Social Security benefits. (Tax-free interest from investments such as muni bonds also becomes provisional income.)
How much income can you earn before your SSI is taxed? The 2011 limits are pretty straightforward:
â€¢ Single person: up to 50% of your SSI can be taxed if your provisional income is greater than $25,000, and up to 85% of your SSI can be taxed if your provisional income exceeds $34,000.
â€¢ Married/head of household: up to 50% of your SSI can be taxed if your provisional income is greater than $32,000, and up to 85% of your SSI can be taxed if your provisional income exceeds $44,000.
Who doesnâ€™t have to worry about this? If your only source of income is Social Security or equivalent retirement railroad benefits, it is unlikely that your SSI will be taxed and you may not even need to file a federal return. In 2011, Social Security benefits are tax-exempt for single taxpayers with provisional incomes under $25,000 and married/head of household taxpayers with provisional incomes under $32,000.
What can be done to reduce (or avoid) the tax? If you are close to hitting either the 50% or 85% tax levels, you may want to think twice about moves that could take your provisional income over the threshold â€“ for example, receiving a sizable chunk of profit from selling a stock, or converting a traditional IRA to a Roth IRA. Here are some common moves people make with the input of a qualified tax or financial professional:
â€¢ Delaying some investment income, rental income or pension income until the following tax year
â€¢ Shifting assets from accounts or investments producing reportable income (like CDs) into tax-deferred alternatives
â€¢ Working less
â€¢ Ramping up pre-tax contributions to an IRA, 401(k) or 403(b)
â€¢ Lowering interest income (such as income from CDs)
â€¢ Lowering tax-exempt interest income (from muni bonds, federal tax refunds, veteranâ€™s benefits, gifts and other sources).
Before April rolls around, it might be wise to consider the different ways to manage taxes on your Social Security benefits. Some new SSI recipients may be taken aback by the tax they end up paying; alternatively, you can plan to reduce it.
Your personal financial consultant – Monty