Did you know that even if you don’t work with a financial adviser, your benefits could be taxable? Many people are caught off guard by this realization. It creates a never- ending cycle of taking money out of retirement accounts to pay taxes on those funds. Not a great situation to be in.
It all started in 1984 when Social Security benefits were first subjected to taxes. Then in 1993, Bill Clinton signed legislation that expanded tax thresholds, making up to 85% of benefits taxable for higher income recipients. Even those who earn less may still face taxes on up to 50% of their benefits. To determine the taxable amount, combined income is calculated using adjusted gross income, untaxed interest, and half of annual Social Security payments.
Over the years, both Social Security payments and federal income tax brackets have shifted to account for inflation. However, the income thresholds triggering taxable benefits have remained the same. This has resulted in a significant increase in the number of people paying taxes on their benefits. In fact, by 2022, nearly half of recipients were taxed, paying a staggering $48.6 billion, as reported by the Social Security Administration.
Sadly, the lack of inflation adjustments means that more and more beneficiaries find themselves subject to the benefit tax. Thankfully, not all of their benefits are taxed, although the average effective tax rate is around 6.6%. It may not seem like much, but it does add up.
To understand the potential taxes you may face, utilize the IRS calculator “Are My Social Security or Railroad Retirement Tier I Benefits Taxable?” on their website. This will give you a clearer picture of your tax liability.
Due to outdated financial mindsets passed down through generations. People are surprised because their grandparents and parents never paid taxes on their benefits. Avoiding the tax can be challenging, especially once required minimum distributions kick in at age 73. However, financial planners suggest strategies such as postponing Social Security benefits and utilizing other income sources like reverse mortgages or leaving retirement accounts for heirs.
Don’t let the tax on Social Security benefits catch you by surprise. Educate yourself and prepare for the impact it may have on your retirement finances.
Erik C. Sussman, CLU®, ChFC®, CFP®, and CEO of The Institute of Financial Wellness founded the company to provide financial education, resources, and services that help people live their best lives.
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