In evaluating your retirement income it is important to understand how your income will be taxed. Many people are confused about why and how Social Security benefits are taxed.

When Congress determined that Social Security benefits paid to high income taxpayers would be taxed, they did not index the incomes above which Social Security would become taxable. As a result, many people now face additional taxes on their Social Security income.

To understand how Social Security is taxed you need some vocabulary:

“Provisional (Combined) Income is modified adjusted gross income (MAGI) plus one-half of social security income plus exempt income.

MAGI = adjusted gross income (AGI) plus certain excluded adoption benefits, education loan interest and/or tuition expense deducted, and excluded foreign income.

Your adjusted gross income (AGI) is your total taxable income less adjustments for things like retirement plan contributions, alimony paid, tuition and fees, and penalty on early withdrawal of savings.

The formula is complicated and depending on where you fall, the inclusion of social security income may throw you into a higher tax bracket – meaning the additional income is being taxed at a higher rate. Also note that dividend and interest income, other retirement plan income, and capital gains are part of your AGI.

 One commentator states that making a portion of social security taxable based on your income is not so much a tax on social security as it is a tax on all your other income.

State Taxation

Most states do not tax Social Security Benefits, the following table summarizes New England states.

Reducing your taxes

To reduce your overall tax burden you can reduce your expenses. Lower expenses means you need less income. Less income means lower taxes. Also if you have significant non-retirement plan savings, you may want to use these prior to taking distributions above the required minimum distributions from your retirement plans to keep your taxable income lower.

Another option, if you are young enough is to contribute to a ROTH IRA. The distributions not only are tax free, but they are not an adjustment for the purpose of determining whether your social security is taxable.

The following example shows how reducing taxable income can be beneficial.

Jack and Myrna are ages 70 and 65. They have $200,000 in savings. Jack has a $400,000 retirement plan and Myrna as $200,000. Jack receives $24,500 in social security and Myrna receives $23,000. Under scenario 1 below, Myrna takes a distribution from her retirement plan of $10,000. Under scenario 2, rather than Myrna taking a distribution, Jack and Myrna take $10,000 from savings. Scenario 2 reduces their taxes by approximately $2,000.