7 Things to Know About Social Security and Taxes

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1. Provisional income is not a simple concept.

As noted, Social Security benefits can become taxable when the beneficiary's "provisional income" exceeds specific thresholds. After the application of the formula, clients can end up paying taxes on up to 85% of their benefits at ordinary income tax rates.

The provisional income formula can be tricky, Elsasser warned. Under the law, provisional income includes half of a person’s Social Security benefits, plus all other taxable income. Other taxable income sources include but aren't limited to dividends, realized interest and realized capital gains. It also includes nontaxable interest earnings, like those from municipal bonds.

"The thresholds for taxable benefits are applied to the provisional income number, rather than the total," Elsasser noted.

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2. Social Security taxation phase-in amounts are low.

In spite of tax brackets increasing annually to account for inflation, the thresholds for determining taxable Social Security benefits are not increased. That produces what Elsasser called "some unusual results." Put simply, a tax-efficient income strategy that works in one year might not work in the next.

For example, a married couple with a $35,000 Social Security benefit in 2023 who withdrew the maximum from their individual retirement account without paying federal tax and are trying to follow the same strategy for 2024 could increase their IRA withdrawal by about 3.4% and get the same result. A couple with $80,000 of combined Social Security benefits, however, would have to reduce their IRA withdrawal by 3.7% to achieve the same result.

"There is no rule of thumb here," Elsasser said time and again.

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3. A 'double threshold' is used to determine the level of benefit taxation.

Elsasser said that many advisors have only a superficial understanding of how taxes are phased in on benefits when a client's income exceeds key thresholds. One key concept to understand in this context is the "double threshold."

"For a single person, the thresholds kick in at $25,000 and $34,000 in Social Security income," Elsasser explained. "Each dollar over the threshold gets taxed at a specific level, depending on whether it has passed only the first or both threshold amounts."

As an example, Elsasser pointed to a person with $25,001 Social Security benefits in 2024. This person will have just 50 cents out of one Social Security benefit dollar treated as taxable income.

"The same rules apply with married couples, but the thresholds are different," Elsasser said. "They are $32,000 and $44,000. Again, these aren't indexed to inflation."

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4. Annual COLAs can cause new taxes to kick in.

Elsasser said that clients and advisors universally appreciate that Social Security benefits are increased each year to account for inflation, providing an important inflation hedge alongside any equity investments the client owns.

However, that the taxation thresholds aren't tied to inflation means the annual COLAs are steadily pushing beneficiaries toward or above the thresholds. This isn't a problem, per se, as people are seeing a net positive via the higher benefit, but it is important to keep clients informed of any new potential tax burden they face — and how this could affect their overall income strategy.

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5. Strategic withdrawals from tax-deferred accounts can help mitigate taxes.

Elsasser said it is important for advisors to realize that clients' income levels alone don't tell the entire story with respect to how much they'll pay in taxes on their Social Security benefit. This is because asset location can have a huge impact on the overall tax burden.

"Let's say you have a married client couple with a $90,000 income need, and they have $40,000 of Social Security income and a $50,000 IRA withdrawal," Elsasser said. "This couple will have a different tax outlook than one with that same $90,000 income target but a higher proportion of it coming from Social Security."

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6. Tax calculation math gets complicated quickly.

Elsasser dug into the aforementioned $90,000 income goal case study to show how tricky the benefit tax math can get.

In this case, the rules require the couple to add half their Social Security benefit to the taxable IRA withdrawal to calculate $70,000 of provisional income. They then apply the first threshold and see that their income is $38,000 over. This amount gets multiplied by 50 cents on the dollar, meaning the couple has $19,000 of taxable benefits.

The couple isn't done yet, however. They next must look at the second threshold, and they are $26,000 over. The rules require them to multiply that excess amount by 35 cents on the dollar, and 85% of this amount is subject to income taxes.

In this example, the second threshold test creates an additional $9,100 in taxable income. Put another way, 70% of the couple’s benefit will be taxable.

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7. Social Security bridge strategies show promise.

Elsasser encouraged advisors to take these complex but important tax dynamics into account when running break-even analyses for their clients.

In many cases, the potential tax savings associated with delaying claiming from one year to the next and instead relying on income from IRAs or 401(k)s will be modest. The differences can really start to add up, however, when one compares the choice to claim at 62 versus 67 or 70 — especially with increasing longevity seeing retirements last well into one’s 90s.

"The important dynamic is to understand how IRA withdrawals that fund the early parts of retirement can reduce the taxable portion of Social Security down the line," he explained. "Ultimately, what we hope to see is that delayed claiming can help us achieve much more tax efficient income over time."

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