How is Social Security Taxed?

The amount of your Social Security benefits that are taxable depends on your “combined income.” Your combined income is equal to your adjusted gross income (“AGI”–the bottom of the first page of your 1040), plus any tax-exempt interest you earned, plus 50% of your Social Security benefits.

• If your combined income is below $25,000 ($32,000 if married filing jointly), none of your Social Security benefits will be taxed.
• For every dollar of combined income above that level, $0.50 of benefits will become taxable until you reach $34,000 of combined income ($44,000 if married filing jointly).
• For every dollar of combined income above $34,000 ($44,000 if married filing jointly), $0.85 of Social Security benefits will become taxable–all the way up to the point at which 85% of your Social Security benefits are taxable.*

Important note: To say that 85% of your Social Security benefits are taxable does not mean that 85% of your benefits will disappear to taxes. Rather, it means that 85% of your benefits will be taxed according to the tax bracket you’re in.

The Social Security “Tax Hump”

The end result of all those calculations is that, if you’re collecting Social Security benefits, your marginal tax rates aren’t as simple as those of other taxpayers. Rather than marginal tax rates that look like this:

…your marginal tax rates might look something like this:

As you can see, rather than steadily progressive tax rates, you likely now have a “tax hump”–a range through which your marginal tax rate spikes temporarily upward. This is the result of the fact that, in that range, each additional dollar of income:

1. Is taxed at your regular tax rate, and
2. Causes an additional $0.50 or $0.85 of Social Security benefits to be taxable.

[Credit for the phrase "tax hump" goes to Carol Tomkovich in her chapter of The Bogleheads' Guide to Retirement Planning.]

Where is Your Tax Hump?

Where your tax hump is located and how far it stretches are a function of how much Social Security benefits you receive.

For single taxpayers:

• Your tax hump begins when when your AGI plus tax-exempt income reaches $25,000 – 50% of your Social Security benefit,
• Your tax hump moves upward when your AGI plus tax-exempt income reaches $34,000 – 50% of your Social Security benefit,
• Your tax hump ends when your AGI plus tax-exempt income reaches $28,706 + 50% of your Social Security benefit.

For married taxpayers filing jointly:

• Your tax hump begins when when your AGI plus tax-exempt income reaches $32,000 – 50% of your Social Security benefit,
• Your tax hump moves upward when your AGI plus tax-exempt income reaches $44,000 – 50% of your Social Security benefit,
• Your tax hump ends when your AGI plus tax-exempt income reaches $36,941 + 50% of your Social Security benefit.

How Does This Affect Tax/Retirement Planning?

As you can imagine, this bizarre tax rate structure results in several tax planning opportunities.

As I mentioned in my book Can I Retire?, when you’re retired and choosing how much to spend from your tax-deferred accounts (as opposed to Roth or taxable accounts) each year, the general rule is that you want to take enough from your tax-deferred accounts to “fill up” your lowest tax brackets.

For example, if you haven’t yet begun to collect Social Security and you realize that your marginal tax rate will increase once you do, you may benefit from converting a portion of your traditional IRA to a Roth IRA now while you’re in a lower tax bracket.

Or if you are already collecting Social Security, you may want to make a point to avoid withdrawing enough to reach your tax hump. Or if you’re already near the high end of your tax hump, it may make sense to withdraw enough to put you through it and up to the top of your 15% bracket so that you can withdraw less next year, thereby allowing you to stay below your tax hump.

*As with many aspects of Federal income tax, there are some exceptions to the normal rules of how Social Security benefits are taxed. For a more thorough discussion, see IRS Publication 915.