This past tax filing season I had to
explain to one taxpayer in the 15% federal tax bracket why $8,000 in additional
qualified dividends and long-term capital gains, which the IRS tells us is taxed
at the rate of 0%, cost $1,097 in federal income tax (13.7%).
And to another, in the 25% bracket, why
$10,000 in additional rental income cost $4,625 in federal income tax (46.25%).
The reason lies in the way Social
Security and Railroad Retirement benefits are taxed.
This could also cause a taxpayer in
the 15% bracket to pay $638 in federal income tax on $5,000 in tax-exempt
municipal bond interest (12.75%).
If you are collecting Social
Security or Railroad Retirement for every $1.00 of additional taxable income
you could be paying tax on $1.50 to $1.85.
And for every $1.00 of tax-exempt municipal bond income you could be
paying tax on 50 to 85 cents.
The amount of Social Security or
Railroad Retirement benefits that are taxed by Uncle Sam depends on the amount
of your other taxable and tax-exempt income.
The maximum amount of benefits that are taxed is 85%. If your gross Social Security benefits,
before deducting Medicare Part B and Part D premiums, is $18,000 the most you
will be taxed on is $15.300.
If, based on your other income, the
maximum 85% of your benefits are already being taxed then every additional
$1.00 in taxable income is taxed as $1.00, and every additional $1.00 in
tax-exempt municipal income is totally tax free (unless you are a victim of the
dreaded Alternative Minimum Tax and you have income from private activity
bonds).
It is important for Social Security
and Railroad Retirement beneficiaries to know where they stand regarding the
taxability of their benefits so that they can understand how much additional taxable
and tax-exempt income will cost in terms of federal income tax.
And so that their tax preparer does
not put them in shock at tax time if they did well in the market or had
additional income from another source during the year.
So here is how Social Security and
Railroad Retirement benefits are taxed –
Start with one-half (50%) of your
gross Social Security or Railroad benefits (from Box 5 of Form SSA-1099 or
RRB-1099) – combined if filing a joint return.
To this number you add all other
taxable income (Form 1040 Lines 7, 8a, 9a, 10-14, 15b, 16b, 17-19, 21).
Next you add the amount of
tax-exempt interest reported on Box 8b of Form 1040. While municipal bond interest is exempt from
federal income taxation, it is included in the calculation of taxable SS or RR
benefits – so in reality up to 85% of tax-exempt municipal interest could be
subject to federal income tax.
From the total of these three
amounts you subtract the total “adjustments to income” from Form 1040 line 23 –
32 plus any write-in adjustments included in Line 36. Deductions for student loan interest, tuition
and fees, and domestic production activities, the adjustments reported on Form
1040 lines 33, 34, and 35, are not allowed in calculating taxable benefits.
If this amount (50% of benefits +
other taxable income + tax-exempt interest – most adjustments to income) is
more than $25,000 (but not more than $34,000) if you file as Single, Head of
Household, or Qualifying Widow(er) or $32,000 (but not more than $44,000) if
you are Married Filing Joint than you will pay federal income tax on up to 50%
of your total gross benefits.
If the amount is more than $34,000
if Single, Head of Household, or Qualifying Widow(er) or $44,000 is Married
Filing Joint you will pay federal income tax on up to 85% of your total gross
benefits.
If you are filing as Married Filing
Separately and you lived with your spouse at any time during the year you will
pay tax on 85% of your Social Security or Railroad Retirement benefits. If you file separately and you and your
spouse lived apart for the entire year you calculate the taxable benefit as if
you are a Single individual.
Click here to download the IRS
Social Security Benefits Worksheet.
Here is another example of how this
method of taxing benefits screws taxpayers. Let’s say you itemized in 2013 and claimed a deduction for
the full amount of state income taxes withheld or paid in via estimated tax
during the year. When you prepared your
state return you find you are getting a $300 refund. When you prepare your 2014 Form 1040 you will
report this $300 refund as taxable income Line 10. If you are receiving Social
Security this could cost an additional $255 of your benefits to be taxed.
If you are in the 15% bracket for
both 2013 and 2014 this $300 provided a tax benefit of $45 on your 2013 return,
but will cost you $83 in federal income taxes in 2014. The solution is to claim the exact amount of
your state tax liability as a deduction on Schedule A instead of the total
amount paid, or to claim a deduction for state and local sales tax.
If we are going to tax Social
Security and Railroad Retirement benefits how should they be taxed? I have suggested we tax these benefits the
same as any other retirement benefit with after-tax employee contributions. Use
the “simplified method” to allocate a portion of each monthly benefit payment
to the total employee Social Security withholdings, or for a self-employed
taxpayer the Social Security share of self-employment tax, as a “return of
contribution”. So a portion of each monthly payment would be tax free.
TTFN
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