Reducing the Taxation of Social Security Retirement Benefits
Dulisse, Richard A., The National Public Accountant
Social Security is a major source of retirement income for most seniors, and anything that affects Social Security is important to them. Seniors have seen increases in the Social Security tax during their working years and during their retirement years. Social Security benefits that used to be tax-free may now be subject to income tax.
Under the current income tax law, some seniors face having up to 85 percent of their Social Security benefits included in taxable income. However, by reallocating their assets, seniors may be able to reduce the tax bite.
Tax on Benefits
The income considered for the potential taxation of one's Social Security retirement benefits is:
* the sum of the individual's adjusted gross income (AGI); plus
* the interest on any tax-free investments; and
* 50 percent of the Social Security benefit being received.
Through a formula demonstrated below, the total is then compared to two different thresholds to calculate the portion of Social Security benefits that will be taxed. The thresholds for determining the potential taxation of Social Security retirement benefits are as follows:
MARRIED, SINGLE FILERS FILING JOINTLY $25,000 $32,000 (taxation of up to 50% of Social Security benefits) $34,000 $44,000 (taxation of up to 85% of Social Security benefits)
An illustration of how these respective income thresholds are applied to the calculation of Social Security retirement benefits is shown in Table 1, page 29.
Let's look at a hypothetical case study. Suppose we have a married retired couple, both over age 65, who receive $15,000 of combined annual Social Security retirement benefits. Their other income consists of $20,000 in pension income, $10,000 from tax-exempt municipals and money market funds, and $15,000 from certificates of deposit and savings accounts. Thus, they have a total income of $60,000. Also assume that they have no mortgage or other substantial itemized tax deductions. They live very comfortably, and actually receive much more total income than they spend. They've successfully planned for their retirement.
However, under current tax law, a large percentage of their Social Security benefits is subject to income taxation. As seen below under Scenario #1, $12,750 of their $15,000 annual benefit (85%) is taxable. To put this into the context of their exposure to federal income taxation, let's assume that they filed a joint tax return in 2002, each took a $3,000 personal exemption, and they claimed a standard deduction of $9,650. Their tax situation looked like this:
SCENARIO #1: CURRENT FEDERAL INCOME TAX LIABILITY Pension Income $20,000 Interest Income 15,000 Tax Exempt Income ($10,000 excludable) -0- Taxable Social Security Benefits ($15,000-$2,250 excludable) 12,750 Total Adjusted Gross Income $47,750 Less: Personal Exemptions and Standard Deduction (15,650) Total Taxable Income $32,100 Tax Liability in 2002 = $4,215.
Using an Annuity to Reduce the Tax on Social Security Benefits
One way for seniors to reduce their taxes is to roll over some of their investments that are producing taxable income into deferred annuities. Annuity products can help to reduce the overall amount of income taxes paid by these seniors in several ways. Let's consider a second scenario to our case study to see what happens.
If the CD assets are transferred to a deferred annuity, the principal grows tax deferred, so the $15,000 in unnecessary income is no longer being generated and needlessly taxed. Second, tax deferred annuities (unlike even tax-exempt securities) are not factored into the formula for calculating the taxability of Social Security benefits. …