Social Security benefit income may lead to a ‘stealth tax’

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This tax season, older taxpayers may find they owe more money to Uncle Sam than they expected.

The reason: More of their Social Security benefits may be taxed following a higher 5.9% cost-of-living adjustment in 2022. This year’s record 8.7% cost-of-living adjustment may also prompt more benefits to be taxed, which retirees may see when they file next year.

Unlike other tax thresholds, the Social Security income levels have not been adjusted for inflation since taxation of benefits began in 1984.

Not moving the brackets or indexing them gradually exposes more and more people to income taxes on their Social Security benefits, according to David Freitag, a financial planning consultant and Social Security expert at MassMutual.

The result is a “stealth tax,” Freitag said.

How Social Security benefits are taxed

Up to 85% of Social Security benefits may be taxed, based on current tax rules.

The levies beneficiaries pay is determined by a formula called “combined” income — the sum of adjusted gross income, non-taxable interest and half of Social Security benefits.

Those who are subject to the highest taxes on benefits — up to 85% — have combined incomes that are more than $34,000 if they file individually, or more than $44,000 if married and filing jointly.

Up to 50% of benefits are taxable for individuals with combined incomes between $25,000 and $34,000, or married couples with between $32,000 and $44,000.

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Individuals and couples with combined incomes below those levels will not pay taxes on their benefits.

If the thresholds had been adjusted for inflation, the initial $25,000 level, where taxes on individuals kick in, would instead be approximately $73,000, according to The Senior Citizens League. The $32,000 initial threshold for couples would be $93,200.

A recent survey from The Senior Citizens League, a nonpartisan senior group, found 58% of older taxpayers want the Social Security thresholds adjusted.

“They are very much feeling that it was ageist, that it was discriminatory, that that threshold has not been adjusted like income tax brackets or the standard deduction,” said Mary Johnson, Social Security and Medicare policy analyst at The Senior Citizens League.

“A lot of them would like to eliminate that tax altogether,” Johnson said.

But changing the thresholds would require the approval of a majority of House and Senate members, which may be hard to come by, Johnson noted.

For now, that leaves it up to beneficiaries to carefully manage their money to minimize their tax bills.

Adjusting withholdings ‘makes all the sense in the world’

One way to help guarantee you will not face a big surprise bill at tax time is to withhold more federal income taxes from your benefits.

With the 2023 8.7% cost-of-living adjustment that went into effect in January, it “makes all the sense in the world” to adjust your withholdings, Freitag said.

Such a move is “defensive planning,” he said.

“Maybe you want to up your withholding a little bit just to make sure you don’t get surprised or shocked next year,” Freitag said.

For many retirees, coming up with a big check to send to the government by April 15 may be difficult. (Tax Day is April 18 in 2023 because April 15 falls on a weekend and Washington, D.C., will honor Emancipation Day on Monday, April 17.)

Having the money taken monthly instead makes it easier, Freitag said.

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To adjust withholdings, beneficiaries need to complete IRS Form W-4V. Beneficiaries may choose among four levels of withholding from Social Security checks — 7%, 10%, 12% or 22%.

Freitag said he typically advises beneficiaries who are concerned about their tax bills to have at least 10% withheld, or perhaps 12%.

Alternatively, beneficiaries may instruct the tax agency to stop withholding federal income taxes from their benefit checks altogether.

You may want to consider reducing your withholdings if you find you’re getting giant refunds, Freitag said, which is like “an interest-free loan to the government.”

Prioritize other income

Beneficiaries who have other funds they can draw from in traditional IRAs or 401(k)s may want to turn there first and delay claiming Social Security benefits, Freitag said.

The reason comes down to the way those sources of income are taxed.

For example, 100% of a $1 withdrawal from a traditional individual retirement account, or IRA, would be reported. (Importantly, this does not apply to Roths, which savers may choose to hold on to, since those withdrawals aren’t taxed.)

However, at most 85% of a Social Security dollar would be exposed to taxation.

“Every dollar of Social Security has a 15% minimum advantage over a distribution from a qualified plan,” Freitag said.

Using qualified money earlier in retirement may help defer filing for Social Security benefits. It may also help retirees get an 85% tax-favored dollar for the rest of their lives, Freitag said.

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