Understanding Provisional Income-s Effects on Your Retirement Taxes

taxes-w-scissors-small-shutterstock_92118476-200x136After you retire, you may be surprised to find that you may have a tax liability on your Social Security (SS) benefits. The IRS assesses this liability by looking at “provisional income” (PI), which is a figure that combines the following three values:

  • Adjusted gross income (AGI)
  • Tax-exempt interest income
  • 50% of Social Security benefits

Based on that amount, and whether you are filing jointly or as a single taxpayer, there are two tiers that determine whether you owe tax on SS benefits.

The first tier applies to single filers with a PI range of $25,000 – $34,000, and joint filers $32,000 – $44,000. At this tier, you must include in your taxable income an amount equaling half your SS benefits or the amount by which your PI exceeds the lower range for your filing status, whichever is less.

The second tier applies to single and joint filers whose PI exceeds the top limits of the first tier ranges. For these people, taxable income includes a value 85% of the amount by which the PI exceeds the top limit, in addition to the amount under the first tier, or $4,500 / $6,000 (single filer / joint filer), whichever is less – the taxable amount cannot exceed 85% of your benefits.

Example:  You’re retired & file a joint return. Your Income = Taxable pension – $20,000; taxable interest dividends and capital gains -$14,000; tax-exempt interest – $6,000; and SS $16,000.  Your PI is $48,000 ($20K $14K $6K $8K (50% of $16K)).  You exceed the $44K level so you’re taxed on $9,400 of your SS benefit…Calculation  equals Tier 1 – $6,000 Tier 2 which is $3,400 (85% of $4,000) 

With this looming liability in mind, there are some strategies you can employ to reduce the tax on your benefits. The key lies in finding ways to reduce your PI below the lower range for your filing. For example, unredeemed bank CDs increase your AGI, so by redeeming them to pay for regular living expenses, your PI goes down. You can make use of “timing” tricks, such as deferring some of your taxable income to next year with gradually maturing investments or selling off your losing stock before the end of the year. And if your IRA allows it, you can reduce the benefits tax every other year by taking twice the distribution one year and taking nothing the following year.

The IRS website offers a worksheet to help you determine what this benefits tax will be—review IRS Pub. 915 at www.irs.gov

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