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#54 - How Social Security Gets Taxed: What You Need to Know

Eric Blake: In past episodes, we have talked about some of the most important aspects of Social Security benefits from filing strategies to the different types of benefits you may be eligible for. But today we're gonna tackle what actually could be the most confusing component of social security, and that is how Social security gets taxed.

Even something called the Social Security Tax torpedo.

Eric Blake: Welcome to another episode of the Simply Retirement Podcast, where we want to educate and empower women to live your retirement on your terms. I'm your host, Eric Blake. If you've been following along with past episodes, we spent a lot of time talking about how important social security planning is, especially for women who may be going through or have gone through a divorce, have been widowed, or maybe just managing retirement on your own.

Social security isn't just another income stream. It is often the foundation of. Your retirement security, and even if it's not the foundation, it is often the only source of retirement income that is guaranteed for life and increases every single year. With inflation and how you plan for it and how you manage taxes around it can have a huge impact.

On the money you actually get to keep. Before we get into everything, I'm gonna introduce Wendy McConnell. Wendy, how are you? I'm good. How are you? I am very good. So I'll I see you right off the top. Have you ever heard of what's called the Social Security Tax Torpedo?

Wendy McConnell: Not even once.

Eric Blake: Not even once. You're gonna learn all about it today.

How's that?

Wendy McConnell: Oh, I can't wait.

Eric Blake: I bet you can't. So here's what we're gonna do. What I wanna do is break down. I'm gonna talk about how Social security gets taxed. I'm gonna talk about what the tax torpedo is related to social security. Also, why it can be dangerous for women who eventually may be filing single later in life.

We're gonna talk about how withdrawals from your retirement accounts can make it worse or actually make it better. And we're gonna talk about, as always, some of these strategies that you can use to minimize things you wanna do now to potentially minimize taxes and, of course, make your retirement income last longer.

Does that sound good?

Wendy McConnell: Yeah, I like it.

Eric Blake: Awesome. So let's start with the very big, the most important part of this, and that is how social security gets taxed. And there's still, there's really, there's a lot of people who actually think Social Security is tax free. Unfortunately it's not, and this is not a political comment one way or the other, whether you should think it should or shouldn't be.

But the fact is, it is not tax free unless you have very low income. Now, one caveat before we get too far into it just, we're gonna talk primarily about federal taxes today. I. There are actually states that do not tax social security benefits, but from our perspective, we're gonna talk about the federal taxation of social security benefits and whether your benefits are going to get taxed or not depends on something called provisional income.

Wendy McConnell: Okay, so let's

Eric Blake: talk about what provisional income is first. This is a special formula that is only used for figuring out how much of your social security is going to get taxed. Okay, so the basics of it is it's a very simple formula. It's your adjusted gross income, plus any non-taxable interest. And this is one of those tricky ones that people don't realize.

So things like municipal bonds or municipal money markets, you actually have to add the interest from those sources of accounts to your adjusted gross income when you're figuring out the taxation of your social security,

Wendy McConnell: even when it's still being, you haven't sold it.

Eric Blake: It's federally tax free. The interest that you earn from municipal bonds or your municipal money market accounts, it is federally tax free, but you have to actually add it back into the formula when determining if your social security is going to be taxable or not.

Wendy McConnell: Ah,

Eric Blake: yeah. Sounds like fun, right? Who came up with that idea? So you've got adjusted gross income plus non-taxable interest, like municipal bond income. Plus 50% of your social security benefits. That is the formula for provisional income. Now, I'm gonna give you one hint right here. One of the things you did not hear me mention is Roth IRA distributions.

And you're gonna find out why as we go through this. But basically, if you think of it like this, your provisional income is basically all your other income, like work IRA, like 401k, distributions and withdrawals, interest, capital gains, plus half of your social security. That's the provisional income formula, okay?

So then let's kinda give an example. So let's think about, somebody's retired and they, maybe they have $30,000 of IRA withdrawals, and then maybe they have 5,000, maybe they do have some municipal bonds. They have $5,000 of tax free. Quote unquote tax free bond interest,

Wendy McConnell: right? So it's not really tax free, right?

Eric Blake: It's federally tax free, but it may actually increase how much of your social security gets taxed, right? So it is definitely tricky.

Wendy McConnell: Yeah. Okay.

Eric Blake: So in our example, you got $30,000 of IRA withdrawals. You got $5,000 of tax free bond interest and you, let's say you got $20,000 of Social security benefits.

Okay, so 30,000 of IRA withdrawals plus the 5,000, that's 35,000 plus half of your social security, that's 10,000. So in that example, your provisional income would be $45,000.

Okay. And this is the only place that number gets used is to determine how much of your social security is gonna be considered taxable income.

Now there are provisional income threshold, okay. And I'm gonna give you a little bit of history on those in just a bit. But basically, for somebody who is a single filer. If your provisional income is less than 25,000, no tax on your social security benefits.

Wendy McConnell: Okay.

Eric Blake: Okay, so tax free. In that instance, it is federally tax free.

If it's all, if that's big, that the only income source you have, then we go to 25,000 to 34,000. If you're in that range, up to 50% of your benefit could be taxable. That does not mean that 50% of it's going to be taxable income up to 50%. So there is a calculation there that has to be done, but somewhere up to 50% will be considered taxable.

And again, if you're a single filer, over 34,000 in provisional income, up to 85% of your social security benefit is going to be considered taxable income.

Wendy McConnell: Okay. Okay. I'm following.

Eric Blake: Okay, stay with me here.

Wendy McConnell: I don't like it, but I'm following.

Eric Blake: Okay. Now let's talk about married filing jointly and this, again, this is going to eventually get us to that point of why for single filers, why these numbers are so critical in helping in creating strategies around this.

A married filing jointly less than 32,000, your social security benefits not taxable. Between 30 2040 4,000, up to 50% of your benefit will be, could be considered taxable income. And then over 44,000. Up to 85% of your benefit could be considered taxable income. So you can see that those, a lot of, we talk about tax brackets, a lot of times single filers, it's a half of whatever the Meyer finally jointly brackets are, but not the case with provisional income.

Again, that's why planning becomes so critical. I. And that's what I wanted to touch on. So those are the ranges. Those are the thresholds for provisional income. But when we're thinking about planning and advance planning, that's why we think about, if you've gone through been widowed or you've been divorced, if you've lost a spouse for some reason, then that pushes you into a filing, single filing status.

That's where these numbers really do become so important because your single thresholds are lower, but they're not meaningfully lower. Again, we talked about, the difference between 0% of your tax, your social security being taxable for a single is less than 25,000, but it's less than 32,000 for married filing jointly,

Wendy McConnell: right?

Eric Blake: Or if you're talking about being 85% of your benefit being taxable, it's over 34,000 for a single filer versus 44,000 for a married finally jointly couple. Okay?

Wendy McConnell: Okay.

Eric Blake: So again, it's one of those hidden taxes that you don't always think about or you don't always realize is out there that could come jump up and grab you.

And this again, what we've talked about on a few different episodes where we talk about this what's called the, what I call the widows penalty, where you might not change your income might not change significantly if you lose a spouse, but this is one of those areas what actually could force you into either higher tax bracket or force you to pay higher taxes, a higher tax rate on your social security benefits.

Wendy McConnell: Okay.

Eric Blake: So a little bit of historical context on this provisional income. So up until 1983. So we think about social security first came into play in 1935. Up until 1983, social security was not taxable. That's actually when provisional income was added to the mix. So if that 1983 rings a bell by any chance at all, I've talked about it in a couple of different episodes.

I've talked about it with. Increasing the retirement age. So that's the year that the increase the retirement age for social security benefits was increased from 65 all the way to 67. It's also when the windfall elimination provision, the government pension offset were implemented. Now, we talked about that with the Social Security Fairness Act, which is now eliminated, those two things.

But that was back in 1983. A lot of changes to the social security system back in 1983 when they were trying to again. Wanna hear a lot about Social security system going bankrupt. They were worried about the exact same thing little over 40 years ago. And these are some of the things they did to try to impact that.

Wendy McConnell: Yep.

Eric Blake: 1993, something called the Omnibus Budget Reconciliation Act. If that doesn't give you crazy head, this is when they added that second layer, which is the up to 85% of your benefit being taxable. Okay. Now here's the big key, and this really impacts people today, is there has not been any infl inflation adjustment on those income thresholds since 1993.

So when we think about the inflation we've seen over the last handful of years, you just think about the inflation we've seen over that's a 30 plus year time period, right?

So the level of inflation we've seen over that time period and the love, the thresholds for provisional income have not changed since then.

So what does that mean? That means many more people are paying tax on their social security benefits because of this.

Wendy McConnell: Okay.

Eric Blake: So a little bit of historical context. So now we start getting into why does this even matter? Why does it, what could potentially happen if we don't understand the taxation rules on social security?

And I wanna walk through a little bit about what that social security tax torpedo actually means. And basically the definition of this is. That for every extra dollar of income you might withdraw or earn from another source. Whether that's you take a little bit extra out of your IRA or maybe you're working, you work a little bit of overtime, even not only does that extra dollar of income get taxed, but it actually could cause more of your social security to become taxable.

Increasing what we would call your effective rate. And think about when you think about what percentage of your income are you actually paying in taxes, that's when we talk about the effective rate. So just a quick example, I actually probably not a quick example. Probably gonna take me a little bit of time to get through this, but I think it's important to understand, so I'm gonna use Sue as our example.

Sus a fictional person, but let's say Sue, she's retired and she's got $3,000 a month of social security benefits, 36,000 a year. And let's say on top of that she's got about 45, let's call it $40,000 in IRA distributions. So probably means she's got somewhere in the neighborhood of, a million dollars in IRA assets.

If she could take $40,000 out, maybe she has a little bit of interest mixed in. But if you just take those numbers, her provisional income in that scenario is about $58,000. So her IRA distributions are 40 plus half of her social security, which is 18,000, 40,000 plus 18, gives us $58,000. So then we say, okay, let's say she's got the standard, her house is paid off, so she just takes the standard deduction.

She can't itemize. So here in 2025, that standard deduction is $15,000 for a single filer. Okay? Okay. Now, if we were to make the assumption she's over 65, it actually would be a little bit more, her deduction would be 17,000, but I'm gonna make this math a little bit easier to get through. But if we think about that, then that puts Sue's taxable income, right at about 50,000.

Which for a single filer smacking the 22% tax bracket. Okay, so for 2022, the taxable, the 22% tax bracket ranges from about, call it $48,000, up to about 103. So for taxable income is 50,000 puts her towards the towards and the lower, as lower range of that 22% tax bracket. And again, what just a reminder is what I talk about, the being in the 22% tax bracket, that's what's called your marginal rate.

So it's meaning that what tax rate is your very last dollar of income gonna be taxed at? So that's your tax bracket, but it's also known as your marginal tax rate. So when people ask you, Hey, what tax bracket are you in? And you say the 12% tax bracket of the 22, that's what we're talking about. So it's the very last dollar of income that you have.

Where did it get taxed? Okay. Okay. So let's say just for conversation purposes, towards the end of the year, she decides she's gonna take an extra thousand dollars out of her IRA account. We hope that it's something fun. Maybe it's a concert or a trip or whatever it might be, but it could be a medical bills because she may not have a choice, you may just have to do it.

So just that extra thousand dollars from her, IRA. Increases her taxable income from her IRA by that thousand dollars, but it also increases the amount of her social security benefit that is considered taxable by $850 because she's above that 85% provisional income threshold. So she takes a thousand dollars out, that becomes taxable.

It increases the social security taxation by $850.

Wendy McConnell: Okay, so

Eric Blake: she only took an extra thousand dollars out. She's gonna pay 22% tax on that thousand dollars. She's gonna pay 22% on another $850 of her social security. So in effect, she's paying $407 on that extra thousand dollars she took out of her IRA for an effective rate of about 41%.

Wendy McConnell: What could she have done instead, Eric?

Eric Blake: We're gonna get to that.

Wendy McConnell: All right, I wanna jump ahead, man. I wanna see how this happen, but that's, again, that's why we

Eric Blake: cut that tax torpedo. So basically, without even thinking about it, when again, maybe she didn't have an option. She didn't, again, maybe it was something fun.

Maybe it was something she had to do. But the bottom line is that extra thousand dollars she took out of her IRA increased her taxable income, not by a thousand, but by 1850.

Wendy McConnell: Okay.

Eric Blake: And again, you end up paying more taxes than potentially is necessary without some of the advanced planning we're gonna talk about here in just a little bit.

And that's, again, that's why the advanced planning matters so much because didn't, the social security taxation doesn't happen in isolation. It's tied to your overall income. So you think about early planning, that's where we start looking at, how can we avoid some of these tax surprises?

What can we do with required distributions? Protect your social security benefits from unnecessary taxation is the bottom line. And again, we think about solo retirees that have been widowed or divorced. That's where some of these numbers become that much more critical. And what you can do today, things you can do today in order to protect yourself down the road.

So when we start thinking about strategies to answer your question, so let's start thinking about, what I talked about from the very beginning when I said, Hey, here's the calculation for provisional income. I did not refer to Roth IRA distributions. So the first thing is, if you are still working, if you have earned income, you want to think about contributing to a Roth IRA account.

'cause distributions from Roth IRAs are tax free. Assuming you meet all the guidelines. Tax free and do not get included in your provisional income number. Okay. I like that. That's number one. Number two is, of course, depending on your other income sources, you might be able to delay taking your social security benefits.

So if you think about, Hey I need to continue working to pay the bills, I have the option I, and if I'm over 62, I could also delay, I could also choose to start Social Security, but I might wanna choose to delay it because of these tax implications.

Wendy McConnell: Okay,

Eric Blake: so you might say, Hey, I can delay that, or I've got, maybe I have the ira.

If I've got a million dollars in an IRA account, maybe I can draw enough income from that initially to again, allow myself to delay your social security benefits. And again, delaying social security. Oftentimes, again, depending on the income situation, what your needs are, your cashflow situation waiting.

Not only does that provincially potentially give you less tax impact, but it also of course increases your benefit. If you say, Hey, I could take it at 62, but if I wait till 67 full retirement age, or I wait till 70, obviously that's also gonna increase your benefit, not just reduce the potential tax implications.

Wendy McConnell: Okay,

Eric Blake: so then we also have withdrawal strategies. So withdraw what I would call with withdrawal sequencing. Which accounts do I take money from? First? So we also, if you're taking money from an IRA, traditional IRA, every dollar that comes outta there is going to be taxable at whatever tax bracket you're in.

And as we saw earlier with the social security tax torpedo, that also could potentially increase how much of your social security gets taxed. So maybe I think about withdrawing from other sources. Maybe I do say, Hey, maybe I can withdraw from a Roth area account. If I had an unexpected expense, maybe I could withdraw from that Roth account.

So I don't get pushed into a higher provisional income number.

Wendy McConnell: Okay?

Eric Blake: Yep. Roth conversions, that's another potential option. So Roth conversions, depending on where you're at in your income scenario, you could convert some of those traditional IRA dollars to Roth dollars. So if you, again, depending on whether you've started Social security or not, that could be an option so that you eventually, when you do have your social security turned on.

Again, gives you another source of income to withdraw from those Roth IRA dollars down the road. So doing Roth conversions, considering that as an option. Again, Roth withdrawals are tax free and they don't count towards your provisional income number.

Wendy McConnell: Okay, so I'm a little confused on the the Roth conversions.

How is that helping me avoid the extra taxation?

Eric Blake: So let's talk about, for example, let's use, and I think it's almost always best to use some type of examples, let's say. So I retired 62. And my intention is to delay my social security benefits until 67.

Wendy McConnell: Okay,

Eric Blake: so I need, I've got a five year window where I've gotta have other income sources.

Depending on what my income needs are, if I've got other retirement assets I can draw from, maybe I've got a taxable, I've got a brokerage account, and that's enough to cover my needs for some period of time. If I've got IRA money that I'm not using and I'm in a low tax bracket. I might say, Hey, if I haven't started Social Security benefits, I've got enough income coming from this other source.

Let me convert some of those pre-tax dollars that I haven't paid tax on. Convert those two Roth I a dollars, so that now going forward, they're tax free. Okay? So when that big expense comes up later down the road after I have started Social Security, instead of saying, Hey, the only place I can take it from is these pre-tax dollars.

I only, I can only take it from my IRA. That extra, just using that extra thousand dollars as an example and say instead of doing that, maybe I can withdraw from my Roth account.

Wendy McConnell: Okay. So that you, that is in

Eric Blake: preparation

Wendy McConnell: of the thousand dollar need for life. Exactly. Gotcha.

Eric Blake: Or, and again, in many cases, what I talk to clients about, a lot of times, I always say, at some point you're gonna have a big expense.

You're gonna call me and say, Hey, I need $50,000. I need a hundred thousand dollars. I always tell again, I just I used the example before. I hope it's something, I hope you're buying an RV to travel across the country. I hope you're taking the, the, a cruise around the world. Whatever it is you're gonna do.

That's what I hope it is for hope it's something fun, but it may not be, it may be a big healthcare expense. But at some point you're gonna call me and say, I need a big chunk of money. I need $50,000. I need a hundred thousand dollars. If the only place I have to take that from is a pre-tax account, an IRA account, or traditional IRA account, or a 401k, and I need $50,000, that means I'm probably gonna have to withdraw 60, 65, maybe even 70,000 out to get $50,000 of spendable income.

On top of that, it also could potentially impact how much of my social security I'm paying tax on.

So that's why the advanced planning becomes so critical in saying, okay, if I have a window, if I'm gonna be in a low tax bracket, should I be thinking about Roth conversion? Should I be contributing to my Roth IRA, if I still have earned income to give myself flexibility?

And that's really what it comes down to. You think about, I talk about when you allocate your investment assets, your retirement assets, think of it kinda like a table. You've got a three legged table, you've got money that's, almost everybody has pre, that's where most people's assets are at, are pre-tax accounts.

IRAs 401k, so that's a third of your table. Your Roth IRA ideally would be, TA would be that second leg at the table, right? Tax free. And then your third is probably gonna be some taxable account. Could be CDs, could be, mutual funds, could be whatever it might be. But you want the three legs at the table.

'cause if you're missing one of those legs, your table's probably not very sturdy. So you always wanna have a good place to take money. You wanna have a smart place to take money depending on what the circumstances are, whether it's a need, a wish, or it's something just unexpected that you just don't have any other sources of income.

Having a good option to take those dollars from is critical when it term in terms of managing taxes and managing some of those, some of these hidden costs.

Wendy McConnell: Okay.

Eric Blake: Does that make a little more sense?

Wendy McConnell: Yeah. And you really do nerd out on this stuff, don't you? I do. I can say your eyes are all light up

Eric Blake: and eyes go big and everything.

Wendy McConnell: You're like tell me you don't understand. I wanna explain it again.

Eric Blake: Hopefully. But hopefully the explanation makes some sense though. That's the key.

Wendy McConnell: Absolutely.

Eric Blake: And then the last thing I'll talk about is managing other income sources. Again, depending on your circumstances, I've also had clients or we've run into situations where come somebody's come to me and said, Hey, my, I had to pay a chunk of taxes on my social security or my other income sources because I sold a house.

People not thinking about capital gains on a on a residence or a second residence. Impacting you from a tax perspective on social security. So managing, make sure you manage capital gains because that is part of your provisional income. Even if it's just a, Hey I spent $10,000 on stock and now it's worth a hundred thousand dollars.

I wanna sell it. Diversify. I. Those gains are gonna impact your social security benefits. Yeah. You wanna be aware of that? Municipal bond interests, I've already talked about that one being quote unquote federally tax free, but it could actually impact your social security taxation, right? So you want to be aware of that as well.

Side income, again, if you've got a part-time job, if you're still working and receiving social security, making decisions on prioritizing, if I am receiving social security, or maybe I shouldn't be, maybe I should use some of the strategies we talked about. A few episodes ago about maybe I should spend suspend my benefits.

If I'm still working and I've got enough income, maybe I could suspend my benefits or, use some of the other strategies we talked about.

So those are just some ideas in terms of, again, planning some of the advanced planning options that are available. And then if we talk about some of the, again, some of the specific issues that, widows face, 'cause we, a lot of our clients have gone through these circumstances well, where if you just some advanced planning why you're still married.

Can make a huge difference because again, we know of, unfortunately with the statistics being that women typically outlive men, if there's things you can be doing today and you are married being, whether that's, again, managing Roth conversions or be preparing in advance, yes, that can be really important.

Again, optimizing your timing of withdrawals from your other accounts tax con Roth conversions, all these different things can really play an impactful role.

Wendy McConnell: Okay. Just be prepared.

Eric Blake: Be prepared and start in advance again, start looking at these things, you can't really, unfortunately, you can't do a whole lot about when you're right in the middle of it.

Yeah. It's some of these things you gotta start doing in advance. Be aware of some of these strategies and say, okay, which one would, which of these apply to me today? Which of things could I implement today in preparation for five years from now, 10 years from now? That's one of the things I always talk about with clients and people when we're having these conversations, is the big advantage we have over the IRS is the IRS only looks as they only care about this year.

From a planning perspective, we have the advantage of looking over not only this year, what can we be doing this year to minimize your lifetime tax liability, but what are the things we could be looking over the next 5, 10, 15 years? To protect you from these, again, some of these hidden costs. Uncle Sam only cares about the tax.

We just had, tax returns were due April 15th. That's less than less than a month ago. That's all Uncle Sam cares about. He's I got the money. That's right. We have the advantage of saying, Hey, let's start looking this year now. That's right. We're right in the middle of that, as a matter of fact, of looking at what should we be doing in May to impact your tax situation this year and next year and five years from now, and 10 years from now.

Okay. So that becomes really important, is that advanced planning. Got it. So just a quick summary of some of the actions that you can take. Again, number one, just understand what's your provisional income number is. If you're in the middle list, know what your provisional income is today. Have an idea, do some projections.

If you are gonna start social security in the next, you call it the next five years, have an idea of what you think your provisional income might be, but have an idea of what that number is and how it's calculated. Make sure that you coordinate your social security and your retirement withdrawals.

That can be really important. Explore wash strategies we talked about either. Number one, if you're still working, you have earned income, you must have earned income to make contributions to contribute to a Roth account, you have to have earned income. If you don't have earned income, but you're able to convert, that's the second option.

Either contribute or convert if it's applicable to you. So explore those Roth strategies. Work with an advisor who understands how to build tax efficient. Income plans. If you're not comfortable with it and you don't know really where to start and you know what's, you know what your provisional income is, work with an advisor can help you calculate that.

Do some projections, do some tax projections and say, okay, here's what you could look like. Are there things we could be doing today to give you a positive impact? The other thing I'm gonna share is that utilize what we call our Social Security Quick Reference Guide. So if you go to our website, we'll actually include that in the links of the show notes.

This is our 2025 Social Security Quick Reference Guide. It'll actually show you what these different provisional income amounts and thresholds are and some of these other social security key facts and figures for this year that you can actually help you in your planning. So that's gonna be something we're gonna share in the summary of the episode.

Hop on there, take a look at that. It's gonna have everything you ever wanted to know about Social Security for the most part. But those are the five things I would suggest as far as, again, helping minimize or understand the taxation of Social Security. Wendy, any other thoughts, questions, clarifications you think that I might need to go back over?

Wendy McConnell: No, I think you did a very good job. A plus.

Eric Blake: I appreciate it. Awesome. That is it for today's episode of the Simply Retirement Podcast. I hope you gave this gave you a little bit clearer picture of how Social Security gets taxed. Why early planning can make a huge difference.

Until next time, please remember, retirement is not the end of the road. It is the start of a new journey.

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