Retirees will see their Social Security payments increase by 1.3% in the new year on account of inflation. Yet, this latest annual cost-of-living adjustment could end up costing some retirees.
For those who do not currently pay federal income taxes on their Social Security benefits, the smidgen of extra Social Security income could cause their benefits to become taxable in 2021. For retirees who already pay taxes on their benefits, the modest extra income could cause their benefits to be taxed at a higher rate.
It all comes down to how the 1.3% cost-of-living adjustment affects what the federal government calls your “combined income.”
How Social Security benefits are taxed
Whether Uncle Sam can tax your Social Security benefits — and the extent to which he can do so — is based in part on the amount of your combined income. This amount is defined as the sum of:
- Your adjusted gross income, or AGI (found on your federal income tax return)
- Any nontaxable interest you earn
- One-half of your Social Security benefits
According to the Social Security Administration, you may owe taxes on up to 50% of your benefits if:
- You file a federal tax return as an individual and your combined income is between $25,000 and $34,000.
- You file a joint return and your household’s combined income is between $32,000 and $44,000.
You may owe taxes on up to 85% of your benefits if:
- You file an individual return and your combined income is more than $34,000.
- You file a joint return and your combined income is more than $44,000.
Note that IRS Publication 915 contains worksheets to help you determine your taxable benefits exactly.
Why so many retirees owe taxes on their Social Security
Half of retiree households owe taxes on part of their Social Security benefits, according to a recent survey from the Senior Citizens League. And the organization argues that percentage is a lot higher than it should be.
Remember, the amount of your combined income isn’t the only factor that determines whether, or the extent to which, your Social Security benefits are taxable.
Another factor is the income thresholds listed above — such as $25,000 for individual tax return filers and $32,000 for joint filers. Those thresholds have not been adjusted to account for inflation since the federal income tax on Social Security benefits started in 1984.
As a result of the thresholds never changing, the tax affects more retirees than originally intended. As we note in “Why Half of Retirees Now Owe Taxes on Social Security“:
“Initially, less than 10% of Social Security recipients were expected to owe taxes on their benefits. Now, Uncle Sam is reaching into the pockets of about half of recipients.”
How to minimize taxes on your Social Security benefits
Retirees who can reduce their combined income can lower the rate at which Uncle Sam taxes their Social Security benefits — or avoid taxation of their benefits entirely.
This could be as simple as withdrawing slightly less money from taxable investment accounts next year to compensate for the 1.3% increase in your Social Security benefits. We detail several other methods in “5 Ways to Avoid Taxes on Social Security Income.”
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