Taxable Social Security income
There are few items on a tax return that are more confusing or more difficult to explain to taxpayers than that of taxable Social Security.
Prior to the late 1980s, Social Security was not taxable. Tax-free income is the best deaa still too good of a deal, because the law was changed to tax up to 85% of gross benefits received.
It seems like the logic in taxing benefits was that this would help extend the time when the Social Security system would go bankrupt. One never knows for sure when trying to figure out where federal tax money ends up, but I find it hard to believe that any of the tax dollars due to taxable Social Security tax end up at the Social Security Administration. I think that big black hole in Washington just sucks up those dollars. I wouldn’t be surprised that at some point in time, 100% of benefits will become taxable just like a distribution from any pension.
The fly in the ointment is that today everyone pays into Social Security. These payments made at the rate of 6.2% of earnings are not voluntary. Granted, employers pay in another 6.2% matching contribution, but employers get to deduct this amount on their tax return. The 6.2% each taxpayer pays represents a nondeductible cost to that taxpayer. Taxpayers should be able to recover the amounts they paid in to the Social Security system using one of two options: either the taxpayer would be able to recover his cost as a nontaxable amount received each year over his life, or he would be able to recover his cost in total from the first benefits received before any benefits become taxable. Either approach has tax theory behind it, but there is a larger book of theory that would require taxpayers to recover their cost over their life.
The Social Security system keeps track of how much tax is paid in to the system by each taxpayer. Up to now, it’s just kept for statistical reasons, because benefits are calculated on earnings, not taxes paid in. But it would not take much of a software program to calculate the taxable benefit based on recovering the taxes paid in. I hope I’m wrong.
However, right now, up to 85% of gross benefits are taxable. To determine how much of that 85% is taxable, we start with total income, not including Social Security benefits received. However, included in the total income figure is income that is not taxable in any other equation.
For example, bond interest from Michigan municipalities is not taxable on the federal tax return, the Michigan tax return, or any city tax return. But it is included as income to determine if Social Security is taxable. This is somewhat of a difficult concept to explain. All taxpayers know that municipal bond interest is not taxable and many believe it doesn’t have to be reported on the tax return. That is incorrect. It does have to be reported on the return and, by the way, it is causing Social Security to be taxable—not a happy conversation to have.
To this modified total income figure is added one-half of benefits received. For joint filers, if the grand total is more than $32,000, the benefits begin to be taxed. For single filers, if the grand total is more than $25,000, the benefits begin to be taxed. Joint taxpayers with a grand total falling between $32,000 and $44,000 will be taxed on not more than 50% of their benefit. Once the $44,000 level is reached, up to 85% of the benefits can be taxed. Single taxpayers with a grand total falling between $25,000 and $34,000 will be taxed on not more than 50% of their benefit. Once the $34,000 level is reached, up to 85% of the benefits can be taxed.
Once the calculation is completed, the final nail in the conversation comes when I have to answer the question of how much tax did the taxpayer have to pay on the supposedly nontaxable Social Security. Sometimes that figure is truly shocking. In the future, it might get even more shocking. This is Jerry Coon signing off.
Jerry Coon is an Enrolled Agent. Action Tax Service is located on Northland Drive in Rockford.
Contact Jerry at Action’s website at www.actiontaxservice.com.