Some of your clients might be under the impression that Social Security benefits aren’t taxable – and they didn’t used to be. But everything changed with the passage of the 1983 Social Security Act amendments, and beginning in 1984, a portion of Social Security benefits were subject to federal income taxes.
According to Jane DeLashmutt O'Mara, portfolio manager at FBB Capital Partners, if an individual has other substantial income from wages, self-employment, interest, dividends or other taxable income, she will probably have to pay federal taxes on their Social Security benefits – up to 85 percent of the total benefit. The more she makes, the more taxes she will pay on her benefits.
In addition to the federal tax, 13 states tax Social Security benefits – Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont and West Virginia.
Unfortunately, there’s no real way for clients to avoid taxation of their Social Security income – but delaying their claims can help minimize their overall tax hit.
“If you don’t have a need for Social Security income at the time, it may make sense to defer your benefit until a later time,” DeLashmutt O’Mara notes. “Delaying your Social Security income could potentially increase your benefit, while lowering your tax burden.”
According to DeLashmutt O'Mara, the IRS uses a calculation to arrive at the tax due on Social Security benefits: The sum of the claimant’s adjusted gross income, plus non-taxable interest (e.g., municipal bonds), plus one-half of his or her Social Security income determines the claimant’s ‘combined income.’
For individual filers earning between $25,000 and $34,000 and joint filers with income between $32,000 and $44,000, up to 50 percent of benefits may be taxable. Above these thresholds, up to 85 percent of benefits may be subject to federal taxes.
Individual filers with incomes below $25,000 and joint filers with incomes below $32,000 will likely not be subject to federal taxation of their Social Security benefits.
Because of the calculation’s complexity, along with other considerations that affect the individual obligation to pay taxes on Social Security benefits, it’s smart to have an advisor on hand to discuss the situation long before benefits start. DeLashmutt O'Mara.
If your client is on the hook for Social Security taxes, they might want to pay quarterly estimated tax payments throughout the year to get ahead of the taxman.
“Beneficiaries might also consider setting up automatic withholding so that taxes are withheld with each check that is distributed,” she says.
Beneficiaries may withhold up to 7, 10, 15 or 25 percent of their monthly benefits, and it can be easier to have federal income tax withheld from Social Security benefits than estimating quarterly tax payments and writing checks throughout the year. In the event your clients do choose to adjust withholdings, the Social Security Administration can provide them with Form W-4V – the Voluntary Withholding Request form.