At the end of 2018, over 62 million people received Social Security benefits. The number includes those receiving Old Age and Retirement benefits and disability.

There are lots of questions surrounding Social Security. Like, when should I apply? When is my full retirement age? What happens if I file early? What happens if I delay?

One of the most asked questions is the title of today's post – is my Social Security income tax-free?

Like most things, tax-related (or government managed), the answer is anything but simple. Taxation of Social Security income falls nicely into that category. In some cases, the income from Social Security is tax-free. In many cases, it is not.

We're going to talk about how taxation works, how to reduce or eliminate it, and how to maximize your Social Security benefit. Deciding when and how to claim is essential to getting the most out of your benefit.

In the end, you will have the information you need to make the best decision.

Three steps to calculate your benefit

Step 1 – Determine the highest 35 years of income

The method for calculating Social Security retirement benefits is not simple.

At age 62, Social Security (SSA) determines your highest 35 years of earnings (indexed for inflation). If you left the workforce for an extended period, your work record would show years where you earned no income.

That is often the case with stay-at-home moms who leave the workforce to raise their children. After the kids are out of school, they often want to go back to work.

However, the gap in the non-working years (which could total 18 years or more) results in several years of zero income. If she has 35 years or less of working years, those years of zero income will be included as part of the calculation. You should always check your earnings record for accuracy.

Step 2 – Determine the average indexed monthly earnings (AIME)

SSA uses the AIME as the basis to calculate your primary insurance amount (PIA). The PIA is the amount you will receive when you reach your full retirement age (FRA). For baby boomers born between 1943 and 1954, your FRA is age 66. If you were born after January 1, 1955, two months is added to your FRA for each succeeding year. Anyone born after 1960 has an FRA of age 67.

SSA sets the maximum taxable earnings amount each year. You pay no SS taxes for income over the maximum. For 2019, that number is $132,900, up from $128,400 in 2018.

When SSA gets the 35-year total income, they divide that total by 420 (35 years X 12 months = 420). That number is your AIME.

They then apply a formula using something called bend points (explained below) to calculate your PIA. Social Security is a progressive system. As such, SSA credits a higher percentage of lower incomes when calculating the PIA.

Step 3 – Calculate the primary insurance amount (PIA)

* The best way to illustrate this is by example:

Baby Boomer born in 1956

Maximum Social Security earnings every year since age 22

AIME = $9,937

PIA formula: $895 (first bend point) x .90 = $805.50 $4,502 x .32 = $1,440.64 ($5,397 (the second bend point) – $895 (first bend point) = $4,502) $4,540 x .15 = $680.95 ($9,937 – $5,397 (second bend point) = $4,540) Total = $2,927.09



PIA = $2,927.00 (Amount worker will receive at full retirement age)

* Courtesy of Elaine Floyd, CFP, Savvy Social Security for Boomers

You can clearly see the highest percentage credit of the bend points (90%) goes to the lowest levels of income. The crediting percentage goes down for the next two bend points. The total of the three calculations is your PIA.

You can learn more about the benefits of delaying Social Security in an earlier previous post where I talk about the top four reasons to delay claiming.

When to claim

Claiming early before FRA (full retirement age) permanently reduces your benefit. The chart below shows the impact of early claiming.

The difference between claiming at age 62 and age 70 for someone whose PIA is age 66 is $1,140 per month. Filing for benefits early would cost them $273,600 in lost benefits if they live until age 90.

None of these calculations account for increases due to inflation. If we average 2.6% inflation, that will make a massive difference in your lifetime benefit, adding even more to the costs of claiming early.

To maximize your income, do the math, and look at all the claiming options before deciding.

Social Security income taxation

With that background, let's dive into the question of whether you pay taxes on your Social Security income.

Each year, the Social Security Administration (SSA) determines the income limits, tax rates, earnings limitation, and many other things. They publish that in October each year to help you plan for the following year. In that publication, the SSA shows the limits in how much income you can earn before having your Social Security income taxed.

The income numbers are for provisional income. The formula for provisional income is AGI (adjusted gross income) + 50% of your Social Security income + tax-exempt interest.

Do you own municipal bonds that pay tax-free interest? Even though you don't pay federal income tax (and possibly state), the income you receive counts when calculating provisional income. Many people, including financial advisors, don't understand that when advising clients on investments.

If you're still working and drawing your Social Security benefit, it's highly likely you will pay taxes on some of your benefits. When you're married and file a joint tax return, and make between $32,000 and $44,000, up to 50% of your Social Security benefit gets taxed. If you make over $44,000, you pay tax on up to 85% of your benefit. That's a big hit.

For singles, the level is even lower. It's $25,000 – $34,000 for the 50% level and those making over $34,000 pay tax on up to 85%.

Tax example

Let's look at an example of a married couple filing jointly.

Combined wages- $50,000 + 50% of Social Security – $18,000 ($2,000 first spouse, $1,000 second spouse = $3,000/mo. X 12 = $36,000 annual X 50% = $18,000) + Tax-free income – zero

Total provisional income – $68,000

Here are the taxes due:

Source: CalcXML

You can see the tax impact for a couple who works while both claim Social Security. The example is even more dramatic for a single filer.

Reducing taxes

With the lower income limits, it makes sense to find ways to reduce your taxable income as much as possible. Here are a few ideas to consider.

Shift investments into tax-advantaged accounts

That should not include municipal bonds. Remember, they count toward provisional income. Consider shifting taxable investments into things like annuities. Those might be fixed index, fixed, or variable annuities. Of course, transferring taxable investments may generate capital gains. Carefully examine the most tax-efficient ways to move money, including cash investments.

Roth IRA

Roth IRAs are one of the best vehicles to reduce taxable income. You can contribute up to $6,000 to a Roth IRA if you fall below the income restrictions. You can add another $1,000 if you are over age 50, bringing the total to $7,000 for 2019. If you hold the Roth IRA for five years, you can withdraw the money tax-free. If you do that while under age 59 1/2, you will pay a 10% early withdrawal penalty. This income does not count toward provisional income for Social Security tax calculations.

If you make too much money and don't qualify for a Roth contribution, consider converting some or all of your traditional IRAs to Roth IRAs. The downside to converting is that you must pay the tax on the converted amount for the year in which the conversion takes place.

An excellent strategy to reduce the big tax hit is to do a Roth conversion ladder. In the ladder strategy, you would convert smaller amounts of your traditional IRAs over several years. The amount of each year's conversion should be below what would move you into a higher marginal tax bracket. The sooner you start the conversation strategy, the more money you can get into the accounts before starting Social Security.

Backdoor Roth

If you make too much money but don't want to convert, another option is the backdoor Roth IRA. The backdoor Roth IRA is simple on the surface. The first step is to make a non-deductible contribution to an IRA. Income limits do not apply for non-deductible IRAs. Once the IRA is in place, the second step is to convert the traditional IRA to a Roth IRA. Here is where some potential pitfalls come into place.

If you have traditional IRAs funded with pre-tax dollars, Roth IRAs funded by converting traditional IRAs, and other non-deductible IRAs, any withdrawals will be subject to the pro-rata rule. That means you will pay taxes on the converted money. The percentage taxed varies based on the pro-rata calculation. Read more about that in this post.

Take IRA distributions early

Required minimum distributions (RMDs) must be taken by April 1 the year following the year in which you turn age 70 1/2 (72 1/2 in 2020). You have no options on that. Though they don't directly count when calculating provisional income, they do count toward total taxable income. Adding the RMD income from IRAs to your total taxable income could move you into a higher tax bracket, thus increasing the tax on your Social Security.

It's best to find a way to reduce the IRA income before claiming Social Security. How? Take money from your IRAs before age 70 1/2 when you have no choice. That way, you control how much you take on how much tax you pay on them.

Delay claiming Social Security

The longer you delay claiming, the longer you delay having to pay tax on your benefit. If you take advantage of the strategies above before claiming, you may be able to reduce your taxable income enough to reduce or eliminate taxes on your Social Security income.

Reduce lifestyle expenses

Lifestyle creep is a topic you hear a lot about these days. Lifestyle creep occurs when our income increases, and we spend the increase on things we couldn't afford before the increase. Those things that were out of reach now become necessities (in our minds). It's a dangerous habit that causes us to go into debt and increase the stress in our lives. It's better to bank the salary increases and maintain the current lifestyle.

Better yet, find ways to reduce expenses, so you require less income to live comfortably. Expense reduction should be a mindset long before retirement. If we need less money to live, we can delay claiming Social Security, reduce our tax burden, and have a less stressful retirement. Paying down debt is a big part of the expense reduction strategy/.

The earnings test

One last thing to cover, not necessarily tax-related, is the earnings test that Social Security applies. When you apply for your benefits before FRA, your benefits get permanently reduced. Refer back to the chart above to find out how much.

If you're working while receiving your benefits, the SSA applies an earnings test that, if you fail, will reduce your benefit even more. Here's a chart of the last five years of the lower and upper limits of earnings for the test.

Source: Social Security Administration

For those exceeding these income limits, SSA withholds $1 for every $2 in earnings over the lower limit. For those exceeding the higher ceiling, they withhold $1 for every $3 of income above the threshold. The income reduction is not permanent. When you reach FRA, the SSA adjusts your income to add back the amounts withheld in previous months or years. It seems like a crazy rule. It's a rule nonetheless. It's important to know this when deciding when to claim.

Final thoughts

As you can see, the rules that govern claiming Social Security are complicated. It's essential to know them to get the most out of your benefit. Taxes are a significant factor in reducing that benefit.

If you work with a financial advisor, make sure they understand Social Security and can help you make the best decisions. Many advisors are not as knowledgeable in this area as they need to be. They should be able to help you calculate your benefit, look at various options, and determine the best ways to reduce taxes on your benefit.

If you're someone who does things yourself, consider Maximize My Social Security to calculate your benefit. Laurence Kotlikoff, professor of economics at Boston University, created the software to guide the decision-making process on claiming Social Security. I would also recommend Dr. Kotlikoff's book, Get What's Yours, The Secret to Maxing Out Your Social Security. It's been revised and updated to reflect the current rules.

It's essential to take the time to learn the rules and get the most out of your Social Security income. Making a quick decision can be costly. Getting it right can add tens or hundreds of thousands of dollars to your retirement income.