Social Security tax: Adding even $1 of additional income can result in a serious increase in tax

It’s fairly common knowledge that your Social Security benefits can be taxed on your income…

It’s fairly common knowledge that your Social Security benefits can be taxed on your income tax return. The problem is understanding how the tax is applied. It can be complicated, and can result in some significant tax increases if you’re not paying attention.

The Social Security taxation cliff is called so because at certain income levels, adding even one dollar of additional income can result in a serious increase in tax. Social Security benefits can be included as taxable at a rate of 85%, 50%, or even zero, depending on your other income.

Read more Social Security news and advice on MarketWatch Retirement

Briefly, when you add all of your non-Social Security income (including nontaxed items such as U.S. savings bond interest and municipal bond interest, as well as your IRA deduction if you happen to contribute) to half of your Social Security benefit for the year, this results in a number that the IRS calls “provisional income” – we’ll call it PI for short. (Here’s a link to a more detailed review of the taxation of Social Security benefits.)

When your PI is less than $32,000 (for married couples filing jointly) or $25,000 for single and head of household filers, then none of your Social Security benefit is included as taxable. Once you go above this initial threshold, a portion of your Social Security benefit will be included as taxable income, firstly at a 50% rate. This 50% rate applies up to the second threshold, coming up next.

If your PI is above $44,000 (married filing jointly) or $34,000 (single or head of household), now a portion of your Social Security benefit will be included at the 85% rate. At a certain point, the 85% rate will apply to your full Social Security benefit, meaning 85% of your Social Security benefit will be included in your taxable income for the year.

So what’s the cliff?

First of all, it’s a bit of a misnomer, because a cliff implies a one-time change to altitude. The Social Security taxation thresholds indeed do change your tax altitude, but it’s not a one-time change. Gradually as income increases above the threshold(s), more and more of your Social Security benefit is included as taxable income.

Here is an example to illustrate:

Meg and Johnny are a married couple receiving Social Security benefits in the amount of $16,000 per year. They also receive a total of $40,000 in retirement funds, from pensions or IRA withdrawals. To keep things simple, they have no nontaxed income to include in their calculations. Below is an illustration of how the Social Security benefit is taxed in their situation.

Modified Adjusted Gross Income

$40,000

2. Plus 1/2 of Social Security Benefit

$8,000

3. Provisional Income (PI, 1 plus 2)

$48,000

4. 2nd threshold amount

$44,000

5. Excess above threshold (subtract 4 from 3)

$4,000

6. 85% of excess (multiply 5 by 0.85)

$3,400

7. Plus 50% of the excess above the first threshold ($6,000)

$9,400

8. 85% of Social Security Benefit (maximum amount that could be taxable)

$13,600

9. To include in gross income (lesser of 7 or 8 above)

$9,400

10. Adjusted Gross Income

$49,400

As you can see, since Meg and Johnny’s PI is above the second threshold just a bit, a portion of their Social Security benefit is included at the 50% rate (line 7) and a portion is included at the 85% rate. Altogether, their Social Security benefit is included as taxable income at a rate of 58.75%.

Now we come to the cliff concept. When you approach a cliff, you’re fine until you take that next step. Same with Social Security taxation — let’s say Meg and Johnny decide to withdraw an additional $1,000 from their IRA this year. Below is how the calculation will play out with this seemingly minor addition:

Modified Adjusted Gross Income

$41,000

2. Plus 1/2 of Social Security Benefit

$8,000

3. Provisional Income (PI, 1 plus 2)

$49,000

4. 2nd threshold amount

$44,000

5. Excess above threshold (subtract 4 from 3)

$5,000

6. 85% of excess (multiply 5 by 0.85)

$4,250

7. Plus 50% of the excess above the first threshold ($6,000)

$10,250

8. 85% of Social Security Benefit (maximum amount that could be taxable)

$13,600

9. To include in gross income (lesser of 7 or 8 above)

$10,250

10. Adjusted Gross Income

$51,250

This addition to income has increased their Social Security taxability rate to 64%, where before it was included at 58.75%.

Increasing their overall income for the year by the $1,000 additional withdrawal results in an increase to their adjusted gross income by $1,850. Normally in this situation, without the Social Security taxation issue, increasing income by $1,000 for this couple would only increase their tax by $120 (using 2022 tax tables). But Meg and Johnny actually have an increase of $222, so that $1,000 withdrawal has cost them 22.2% in taxes.

In a similar fashion, if Meg and Johnny were able to reduce their PI by $1,000, this would decrease their taxable Social Security benefit to $8,550, or only 53.34% included.

What can you do about it?

First of all, understand that this situation only occurs in the limited PI ranges between $32,000 and roughly $50,000 to $60,000 (for married filing jointly). For Meg and Johnny, their Social Security benefits become fully 85% included as taxable when their PI is above approximately $53,000. For singles and heads of household the range is between $25,000 and approximately $40,000. If your PI is below those thresholds, you have zero includable Social Security income as taxable. Above the upper range, and your Social Security benefit will be 85% included as taxable income.

If you’re in the middle somewhere, you might want to pay close attention to how your benefit is taxed. If you can control your income somewhat, you could bunch some income in one year (and take the tax hit), making the following year (or the prior year) a more lean income year.

If IRA Required Minimum Distributions (RMD) are the culprit taking you up over the threshold(s), you might consider doing a Roth conversion in order to bring down the amount of your RMD. A systematic Roth conversion strategy prior to actually starting to receive Social Security benefits might pay off very well by reducing your included Social Security benefits.

Just keep in mind that doing Roth conversions can impact other income-related items, such as Medicare premiums.