Social Security Income Funding and Taxation

After decades of working, saving money, and just plain navigating life, retirement approaches and shocks you with its complexity. The number of things to consider when planning a retirement is daunting, and Social Security is no exception. While the options have been reduced slightly in the past few months, there’s still a lot to consider when claiming the benefit that you’ve funded and earned after all those years. I’d like to clarify just a few aspects of Social Security: how it’s funded and how it’s taxed when received.

First, consider how Social Security is funded. It’s financed through a dedicated payroll tax. Employers and employees each pay 6.2% of wages into Social Security, while the self-employed pay 12.4% of earnings. According to Social Security’s website, in 2013, 85% of total Social Security income came from payroll taxes, while another 12% came from interest earnings.

I share this because many people have heard that Social Security is bankrupt, and because many people believe they paid taxes on their earnings and will then have to pay taxes on their Social Security income, that it’s double taxation! Well, sort of, but not quite. The tax on wages while working is what actually creates the benefit; it’s the equivalent of having money deducted from your paycheck to invest in a 401(k). The taxation of wages was the reason you have Social Security benefits coming to you at all. Will those benefits be taxed when received? Quite possibly, but we’ll get to that. 

As for Social Security being bankrupt, that’s not accurate. As long as there are payroll taxes, Social Security will have money coming in to cover benefits, as it always has. There’s a question of whether there will be enough tax revenue coming in to pay all of the promised benefits, but it’s not as if there’s no money in Social Security. Hence, changes are being made to Social Security to correct the shortfall for future generations.

So what are the tax rules of Social Security? In short, Social Security benefits are taxable to you if you make enough money from other sources. The means by which your Social Security tax is determined is called the ‘provisional income formula.’

The Provisional Income Formula:
Your adjusted gross income (AGI)
+ Nontaxable Interest
+ ½ of your Social Security Benefits
= Your “combined income*”

Once you’ve determined your “combined income” you apply that amount to the following (example is for a married couple filing a joint return; single filers have different amounts):

If you and your spouse have a combined income* that is

• between $32,000 and $44,000, you may have to pay income tax on up to 50% of your benefits
• more than $44,000, up to 85 percent of your benefits may be taxable

So while you may have heard that up to 85% of Social Security benefits are taxable, the actual amount is based on your combined income. Just to clarify, because up to 85% of benefits are taxable doesn’t mean you’re paying 85% tax on those benefits. Instead, it means not all of your Social Security check is taxable, just part of it.

As this should illustrate, Social Security taxation is not necessarily simple to grasp, but there’s a formula available to determine how much of your benefit will be taxable to you. Additionally, the system isn’t bankrupt, but adjustments will need to be made in order to ensure future workers and retirees will receive the benefits they’re entitled to.

If you have specific questions, please let us know or reach out to your tax preparer for tax advice.

All the best,

Adam Cufr, RICP®