IRA withdrawals with Social Security benefits can pile up taxes

The United States tax code is confusing, to say the least.

Some sections are easier to follow than others; the taxation of Social Security benefits is not one of those.

Prior to 1984, Social Security retirement income was not taxed. But with bipartisan support after the Greenspan Commission recommended taxing a portion of benefits to help shore up the system, former President Ronald Reagan signed the law allowing taxation of up to 50 percent of benefits, depending on the taxpayer’s other income. In 1993, within the contested Omnibus Budget Reconciliation Act, President Clinton presided over increasing that maximum to 85 percent. 

And once the door to a tax is opened, it’s tough to shut it again.

So who does include Social Security benefits in their income? Since it coordinates with other income, not everyone. For a taxpayer who only has Social Security income, the benefit will not be taxed. Up to a certain income limit, the benefit will still not be taxed. But after crossing that line of taxation, the amount taxed goes up swiftly.

Taxation happens in stages

Social Security taxation happens in stages, and is based on your provisional income. Provisional income is made up of your modified adjusted gross income (MAGI), plus one half of Social Security income, plus tax-exempt interest.

Modified adjusted gross income is adjusted gross income (AGI), plus any amounts excluded under an employer’s adoption assistance program, student loan interest deductions, tuition deductions and foreign earned income.

Adjusted gross income is the number at the bottom of your Form 1040, and includes all taxable income, less things like the MAGI adjustments just mentioned, IRA deductions, self-employed health insurance deductions, health savings account deductions and some others.

The first stage of taxation, with up to 50 percent of benefits taxed, happens when provisional income reaches $25,000 for single taxpayers and $32,000 for married couples. That 50 percent maximum of benefits taxed holds until the second stage is reached, at $34,000 for singles and $44,000 for married couples. At that point, up to 85 percent of benefits are taxed. The calculation of the exact amount of benefit included in your income requires a 19 line IRS worksheet to figure out, found in Publication 915. If you anticipate any of your Social Security income being taxed, I recommend getting help preparing your taxes, either through software or a professional. Note that being taxed does not necessarily equal having to pay tax on it. It is included in income that is taxed, but your deductions and exemptions come off before the tax is calculated.

First and second thresholds

For taxpayers under the first threshold (nothing taxed) or well over the second (85 percent taxed) things are pretty straightforward. The same for married couples living together at any point during the year but filing separately; 85 percent of their benefit is automatically included in income. But for folks in the middle, tax planning can avoid unpleasant surprises.

Let’s use the example of Betty, a widow, living on a modest income of Social Security and a pension. None of her Social Security benefits are taxed. In fact, her taxable income is zero so she has no federal tax liability at all. Betty decides to withdraw $10,000 from her IRA account to spend the winter in Florida. Some of her Social Security becomes taxable (25 percent in this case), and her total tax is now about $1,000. Not bad, at 10 percent of her withdrawal.

Let’s say Betty decides to add a second withdrawal this year of $5,000 for home repairs. Now about 50 percent of her Social Security is taxed, and her tax due will be $2,400. That additional $5,000 withdrawal cost her $1,400 more, or 28 percent, in tax.

What happens if Betty wants to go to Florida next year too and takes the $10,000 this December to get a jump on the rental? Her total withdrawals now sit at $25,000, and that last $10,000 adds $3,700 to her taxes, meaning she was taxed on it at 37 percent. Ouch. Had Betty planned and spaced out her withdrawals, her taxes could have been quite a bit less. That’s what we call a stealth tax.

Since the tax was imposed to help stabilize Social Security, most of the revenue goes into the Social Security system. A portion of the tax imposed on “high income beneficiaries,” those taxpayers exceeding the $34,000/$44,000 secondary threshold, goes into the Medicare Part A system.

Isn’t this double taxation though? After all, we’ve been taxed on the money we paid in once already. How does the government justify taxing it again? Actually the rationale for the 50 percent number had its basis in the idea that employees only pay in 50 percent of their Social Security tax; the employer pays the other half. So really, it’s not all your money — that line of thinking goes anyway. For the 1993 change, the ideology was that the higher 85 percent more closely mirrors private pension plans, where the growth and employer contribution are taxed but not the money you contribute. It was interesting to me to learn that there really was an attempt at justification.