The confusing taxation of Social Security benefits
Columnist explains the confusing way that Social Security benefits are taxed; also offers advice on 401(k) distributions.
Q: I am confused about the taxation of Social Security income. I have a pension of $88,000 a year. I am eligible for Social Security in two years — about $1,900 monthly.
Based on all other itemized deductions, my net income tax is about 16 percent.
When I start to withdraw Social Security, will I pay 85 percent of it in tax, or will I pay 16 percent of 85 percent of it?
A: You’ll pay 15 to 25 percent in taxes on 85 percent of it. The taxation of Social Security is confusing because it is based on a complicated formula.
Basically, as your income from other sources increases, a portion of your Social Security income is added to your taxable income.
At the limit, 85 percent of your Social Security benefits will be added to your taxable income. This is called your modified adjusted gross income.
With a pension income of $88,000, you can count on having 85 percent of your Social Security benefits added to your taxable income.
As a result, your taxable income before deductions will be inflated by that amount. There is bad and good news here.
The bad news is threefold: First, you will have to pay income taxes on an income that you didn’t think would be taxable.
Second, the tax is structured so that your effective marginal tax rate on additional income from other sources (such as pensions and retirement account distributions, etc.) will be higher than the 15 and 25 percent tax rates that are commonly experienced.
Third, the formula for the tax is not indexed to inflation. If you don’t like the tax, your children will absolutely hate it because they will pay it at much lower levels of income.
And the good news? Simple. It’s a tax that has a beginning and an end. It starts when your income from other sources exceeds a certain amount. It ends when 85 percent of your Social Security benefits have been added to your taxable income.
Once you clear that hurdle, each additional dollar of income from other sources will be taxed at normal marginal rates, like 15 or 25 percent.
For you this will be important because you’ll pay the entire burden on the basis of your $88,000 pension alone. This means you won’t be paying at higher than normal effective marginal rates on income from other sources, such as an IRA rollover.
Q: I will be 70 next April. I currently have $410,000 in a 401(k). How can I avoid the minimum required distribution (MRD) and still have the flexibility to make a withdrawal if needed in the future?
A: The only way to avoid taking the MRD starting at age 70½ is to do everything you can to convert to a Roth IRA. But that means paying taxes in a single lump rather than spread out over the rest of your life. Spreading the taxes out over many years is probably the better route.
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