Unexpected tax liability for retirees

Of course, taxes are a major concern when you work full time for a living. Unfortunately, you may also have to pay federal income tax on a portion of the Social Security benefits you receive during the year—even though you’ve paid Social Security tax all the years you have been working.

Background: There is a two-tier approach to taxing Social Security benefits. Unlike many other provisions in the tax code, the thresholds for the tiers are not indexed for inflation and remain on the relatively low side. The following is a brief summary of the main rules.

Tier No. 1: If a taxpayer has provisional income between a base amount of $32,000 and $44,000 ($25,000 and $34,000 for single filers), he or she must pay tax on the lesser of (a) one-half the benefits or (b) 50% of the amount by which provisional income exceeds $32,000 ($25,000 for single filers).

Tier No. 2: If a taxpayer has provisional income above $44,000 ($34,000 for single filers), he or she must include in taxable income 85% of the amount by which provisional income exceeds $44,000 ($34,000 for single filers) plus the lesser of (a) the amount determined under Tier No. 1 or (b) $6,000 ($4,500 for single filers). In no event, however, can the amount exceed 85% of the benefits received. Note: There are special rules for married taxpayers filing separate returns.

For this purpose, “provisional income” is defined as the taxpayer’s adjusted gross income plus tax-exempt income plus one-half of Social Security benefits. In other words, if you receive tax-exempt interest from investments such as municipal bonds, it can increase the tax on Social Security benefits.

Perhaps the best way to understand the full impact of the rules is to look at an example.

Hypothetical situation: For simplicity, say that Mr. and Mrs. Golden, a retired couple, have the same income each year. They receive a taxable pension of $22,000, taxable interest of $10,000, tax-exempt interest of $10,000 and Social Security benefits of $12,000. Based on those amounts, their provisional income is $48,000.

Because the Goldens have provisional income above $44,000 this year, they will be taxed on $9,400 of their Social Security benefits—$6,000 from Tier No. 1 plus $3,400 from Tier No. 2. The calculation is as follows:

Taxable pension                                                                                  $22,000

Taxable interest                                                                                   $10,000

Tax-exempt interest                                                                            $10,000

Subtotal                                                                                               $42,000

Provisional income

($42,000 plus 50% of $12,000)                                                          $48,000

Total tax

($6,000 plus 85% of $4,000)                                                              $9,400


Caution: Understandably, there is a great deal of confusion in this area. A JMF professional tax adviser can help apply the rules to your situation.