Monday, June 10, 2013


I am often asked to explain how Social Security, and Railroad Retirement, benefits are taxed.

Back when unemployment benefits first became subject to federal income tax I remember my mentor and I saying that next they will tax Social Security benefits.  And we were right.

1984 was the first year that Social Security and Railroad Retirement benefits were taxed.  Originally the maximum amount subject to tax was 50% of your total gross benefit.  The Deficit Reduction Act of 1993 increased the maximum to 85%.

The amount of your benefits that is subject to federal income tax depends on the amount of your other income – both taxable and tax-exempt.

The calculation of taxable benefits starts 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.  Although this worksheet is for the 2011 Form 1040 it also applies for 2012 and 2013.

You can see that, because of the way Social Security and Railroad Retirement benefits are taxed, it is possible that for every $1.00 in additional taxable income you receive from other sources you will be taxed on $1.50 or $1.85!  So it is important that benefit recipients who are not already paying tax on the maximum 85% of benefits plan carefully to reduce their Adjusted Gross Income (or in this case a Modified AGI).  This is just another example of why AGI is the most important number on your tax return. 

We are told that long-term capital gains and qualified dividends are taxed at the rate of 0% if you are in the 10%-15% brackets.  But this income increases your MAGI for purposes of calculating taxable Social Security or Railroad Retirement benefits.  So if you have $1,000 in qualified dividends, which you expect to be totally tax free due to the 0% bracket, you could end up paying tax on as much as $850 at your "normal" ordinary income rate!

Here is a tax tip.  If you itemized in 2012 and claimed as a deduction the full amount of state income taxes withheld or paid in via estimated tax during 2012, and report income on Line 10 of your 2013 Form 1040, your net taxable income for 2013 could be increased by from 50% to 85% of this state income tax refund. 

But if you deducted only the actual amount of state income tax liability (from your 2012 state income tax return) on your 2012 Schedule A, then you did not receive a “tax benefit” from the amount of your refund, and nothing needs to be entered on Line 10 of your 2013 Form 1040.  The refund will not increase your taxable benefits. 

By doing this your 2012 federal refund is slightly reduced, but the reduction in federal income tax liability on your 2013 return is more than the reduction in the 2011 refund – so you are net “in pocket” for the two years.

If 2013 is the first year you will be collecting Social Security or Railroad Retirement (either disability or normal retirement) benefits you should visit your tax professional before the end of the year to do some calculations.

Any questions?

An afterthought - there is another way that tax-exempt municipal bond interest can end up biting you in the arse.  The amount of exempt interest reported on Form 1040, or Form 1040A, Line 8b is added to your AGI to determine if you will be charged a higher Medicare Part B premium.


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