From what I've read, if a married couple has annual withdrawals from 401(k)s, IRAs or pensions that exceed a certain amount, their Social Security benefits may be taxed. Is that true?
-- A Reader
You're absolutely right. When it comes to income taxes, many people think only of the money they earn in a paycheck. But the reality is that there are many other types of income that are subject to ordinary income taxes. And all of that income, in turn, can trigger taxes on Social Security benefits -- which can come as an unwelcome surprise.
To determine whether your Social Security benefits will be taxed, the IRS uses what it calls your "combined income" -- which is the sum of your adjusted gross income (AGI), non-taxable interest, and half of your Social Security benefits. If your combined income exceeds a certain limit, 50 to 85 percent of your benefits may be taxed.
All this is probably enough to send you running to your accountant. But before you do, let's go over some of the facts so you can have a more meaningful discussion.
Retirement account withdrawals that are subject to income tax
A withdrawal from a retirement account is considered to be ordinary income and is taxed as such with a few exceptions, depending on the type of account. Here are the most common retirement accounts and how they're taxed:
- Traditional IRA, 401(k), 403(b) or other employer-sponsored plan: Earnings and pre-tax contributions are taxed at ordinary income tax rates. If you made after-tax contributions, a portion of your withdrawal will be taxable and a portion will be tax-free.
- Roth IRA and Roth 401(k): Both contributions and earnings are income tax-free once you reach age 59½ and you've held the account for 5 years.
- Pension: If all contributions were made with pre-tax dollars, withdrawals are treated as ordinary income.
- Annuity: It depends on the type of annuity. Any gain from purchased annuities, such as fixed and variable annuities, is treated as ordinary income. Best to talk to your tax advisor.
Other sources of taxable income
Many retirees have other sources of income besides retirement accounts. So it's important to remember that taxable income also can include self-employment income, as well as unearned income such as dividends and interest, capital gains and U.S. Savings Bonds.
Alimony, unemployment compensation, gambling winnings or lottery winnings are additional sources of taxable income.
How much income you can have before benefits are taxed
As I mentioned, whether or not your Social Security benefits will be taxed depends on your combined income. For 2014, a married couple filing jointly with combined income under $32,000 ($25,000 for single filers) won't pay income taxes on their benefits.
However, if their income is between $32,000 and $44,000 ($25,000-$34,000 for single filers), up to 50 percent of Social Security benefits may be subject to ordinary income taxes. If their income exceeds $44,000 ($34,000 for singles), up to 85 percent of benefits may be taxed.
Here's a simple example: In 2013, Ted and Marsha each withdrew $20,000 from their 401(k)s. They also had $1,000 in dividends and interest. They had no deductions, so their AGI was $41,000. They also had $1,500 in non-taxable interest income, and together they collected $36,000 in Social Security benefits. Their combined income for purposes of computing the taxability of Social Security benefits (the tax-exempt interest is still non-taxable) was $42,500 plus $18,000 (half of their Social Security benefits) for a total of $60,500, putting them well over the $44,000 limit. You can see how easily it adds up.
What you can do about it
If paying taxes on your Social Security benefits seems inevitable, you can strategize a bit to help minimize the pain. First, if you haven't yet filed for benefits, think about the best time for you and your spouse. It may be wise for one or the other of you to delay filing for benefits, not only to keep taxes low, but also to let your benefits grow.
Then, as you plan or refine your retirement income strategy, take a look at all your sources of income (including required minimum distributions from retirement accounts once you reach 70 ½) and divide them into taxable and non-taxable categories. See how much of your retirement expenses you can cover from sources not subject to ordinary income taxes. If possible, keep withdrawals from your retirement accounts low enough to stay in a lower tax bracket -- and potentially lower the percentage of Social Security benefits that may be taxed.
Now talk to your accountant
Once you've looked at the broad numbers, you can use calculators on the Social Security website to explore different scenarios and determine how much you may be taxed. But to really get a handle on the numbers, I suggest talking to your accountant.
If you do have to pay taxes, you can make quarterly estimated tax payments or choose to have federal taxes withheld from your benefits. Whichever you decide, at least there won't be any surprises.
Looking for answers to your retirement questions? Check out Carrie's new book, "The Charles Schwab Guide to Finances After Fifty: Answers to Your Most Important Money Questions."
Read more at http://www.schwab.com/book. You can e-mail Carrie at email@example.com. This column is no substitute for an individualized recommendation, tax, legal or personalized investment advice. Where specific advice is necessary or appropriate, consult with a qualified tax advisor, CPA, financial planner or investment manager.
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