April 5, 2019
Sunday mornings are always busy in the Cutter household. I allow myself to sleep to 6 a.m., exercise, then retreat to my home office where I succumb to deep thought and write our financial discussions for the week before we leave for church at 11. My girls have learned over the years if they see the office door shut not to bother their old man. This routine has taken years to cultivate. Before the teenage years, the twins would try to sneak up and sit at the desk next to me to pretend they were writing with me. Now as teenagers, I realize how much I miss those days.
I try every week to tackle complicated financial issues and how they impact us on Main Street. While Social Security and its impact on retirement may not be the most interesting topic, it is one that must be discussed to help put you in the highest probability of financial success. So, this week let’s dive right in to see if we can shed some light on this complicated topic.
Social Security is arguably one of the most important social programs we have in this country. More than 62 million people each month receive a Social Security check.
However, Social Security is also rife with misunderstandings. In my practice, one of the most common questions Jen and I receive is how Social Security and taxes work and how it fits into income planning.
It does not matter what financial lifecycle you are currently in, accumulation or distribution, everyone must go online to the Social Security website (https://www.ssa.gov/myaccount/) to create an account.
This account gives you access to your personalized estimate of your future benefits. It also allows you to double check your earnings history for accuracy, see your current statement, and access other important Social Security information.
We find that most folks are under the impression that what they review on their benefit statement is what they will actually receive as their full benefit amount.
While that would be nice, unfortunately, the full benefit amount doesn’t take into account the taxes you may have to pay on those benefits when you receive them.
The reality is that most of us will end up paying at least some taxes on our Social Security benefits. While approximately 40% of people who receive benefits every year pay taxes on them, that statistic can be somewhat misleading for a few reasons.
As residents of the Commonwealth of Massachusetts, our state per capita income is almost $71,000 annually which is the 7th highest per capita income in the country. So income planning in retirement becomes critical since earned income will help to determine whether or not we’ll pay taxes on our Social Security, and if we do, how much we’ll pay.
It is hard to believe the first Social Security benefits paid out in 1940. From 1940 to 1983, Social Security benefits were not taxable. In 1993, when Congress got involved, it all changed – not to the tax-payers advantage.
Generally speaking, there are three thresholds used to determine taxable income on benefits received. For example, if you’re married filing jointly on your 1040 and your combined income is less than $32,000 annually, you fall into the “tax-free” zone. If your combined income is between $32,000 and $44,000, you jointly may have to pay tax on up 50% of your benefits. Lastly, if your combined income is more than $44,000, you may have to pay tax on 85% of your benefits.
Determining a combined income becomes critical. The first step is to determine your adjusted gross income (AGI). AGI is defined as the amount of income calculated from your gross income and used to determine how much of your income is taxable. It can be located on page one of your 1040. Next, add both non-taxable interest (an example would be municipal bond interest) and 50% for your Social Security benefits to your AGI to arrive at your combined income.
When Congress passed the tax changes in 1983 and subsequently in 1993, they did not provide for any indexing to the income thresholds. In other words, those thresholds are the same as they were in 1993, pushing more and more retirees out of the “tax-free” zone. Therefore, more retirees are paying tax on Social Security benefits.
In fact, only 18% of people had to pay any tax on their Social Security benefits back when the first tax was implemented, now it is closer to 40%. The government is collecting tax on a program that was never meant to be taxed.
Let’s review a recent example Jen and I had a few weeks back. We met with a couple, Bob and Judy, from West Falmouth. They came to us to develop a sound retirement system that will last them for the rest of their lives. Both are 66 years-old retirees and file their tax returns as married filing jointly.
Bob and Judy are receiving their annual Social Security benefits of $40,000. They’re combined adjusted gross income (AGI) is just under $75,000 and they have a non-taxable bond interest of about $6,500.
To calculate their combined income, take their AGI of $75,000; then add the $6,500 bond interest back and 50% of the Social Security of $20,000. Resulting in $101,500 of combined income.
With a combined income of $101,500, which is more than the top threshold of $44,000, our West Falmouth friends are going to owe tax on 85% of their Social Security benefits. We conclude that 85% of $44,000 is $32,000 which is the amount to be entered on page one of their 1040 where it will be subject to income tax rates.
We estimated Bob and Judy’s federal tax liability, as it relates to their Social Security benefits, to be about $5,800. Unfortunately, they did not anticipate this tax.
Taxes are complicated, and for most, Social Security is essential; building a sound retirement system is a necessity. Make sure you reach out to a qualified retirement specialist with the capacity to help put you in the highest probability of financial success.
Be vigilant and stay alert because you deserve more.
Jeff Cutter, CPA/PFS is President of Cutter Financial Group, LLC, a wealth management firm with offices in Falmouth, Duxbury, and Mansfield. Jeff can be reached at firstname.lastname@example.org.
Cutter Financial Group LLC (“Cutter Financial”) is a SEC Registered Investment Advisor.
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