The taxation of Social Security benefits depends on several complex calculations.
The first step is to calculate your provisional income, which is your gross income plus tax-exempt interest plus one-half of your social security benefit.
You then need to look up your base amount: $25,000 for a single, head-of-household, or married filing separate, (living apart all year), $32,000 for married filing joint and $0 for married filing separate (not apart all year).
If your provisional income is more than the base amount, your benefits start being included as taxable income at a rate of 50 percent. This continues until you hit the second threshold of benefit taxation.
The second tier of base amounts is $34,000 for single, head-of-household, or married filing separate (apart all year) and $44,000 for married filing joint and $0 for married filing separate (not apart all year).
As your provisional income climbs above the second tier amounts, 85 cents of every dollar over becomes taxable. This continues until a full 85 percent of your Social Security benefits are taxed.
There is good news in that there are several proven strategies you can use to potentially reduce or eliminate the tax on Social Security benefits. Unfortunately, tax exempt interest is not one of them, since tax-exempt interest is added back in when calculating provisional income and taxability of benefits.
Tax-deferred annuities can be used to reduce both taxable income and the tax on Social Security benefits. Since you can control the taxable gains distributed from the annuity, you can often control what, if any, Social Security benefits are taxable.
Investments in capital gains oriented investments can also reduce the tax on benefits because ordinarily little income is recognized currently. Bunching of income into alternate years could reduce the tax on benefits every second year.
With several options available to you, this is an excellent opportunity for your financial advisor to put together an effective strategy to reduce the tax on your benefits.
Many people don’t think about Social Security until they near retirement age, but most of us should give the subject a bit more thought.
The General Accounting Office estimates 1 out of every 13 workers haven’t had all of their earnings credited to their accounts. Since the Social Security Administration is only required to correct errors within three years, we recommend you review your account annually online.
When you are working and under the full retirement age (FRA), you also need to be concerned about the limit on the amount you can earn and still receive full Social Security benefits. For those under their FRA benefits are reduced $1 for each $2 earned over $14,160 in 2011. The full retirement age is 66 for those born in 1943-1954 and then increases after that.
You are exempt from earning limits the month you reach your FRA. For months in the calendar year you reach your FRA but before reaching FRA, your benefits are reduced $1 for each $3 over $37,680 for 2011.