Understanding Provisional Income
An important factor when creating your retirement income plan is deciding when to claim your Social Security benefits. However, something that is often overlooked is the potential taxation of your benefits if your income exceeds certain annual limits.
These annual limits are based on “provisional income” which is adjusted gross income + tax-exempt interest (which could be interest from municipal bonds and savings bonds) + 50% of social Security benefits.
“Provisional Income” Formula Used by the IRS:
Adjusted gross income + Tax-exempt interest + 50% of Social Security benefits
If your “provisional income” exceeds the levels shown below, you may owe federal income tax on up to 50 percent or 85 percent of your Social Security benefits. The levels are different depending on your tax filing status, but they are not adjusted for inflation.
Example of the of Taxability Social Security Benefits
For example, a married couple (filing jointly) has $1,000 interest income, $10,000 dividend income, and $4,000 tax-free interest; $30,000 of IRA income; and $30,000 annual Social Security benefits (of which only 50 percent, or $15,000, is used in the formula for provisional income to determine the taxability of Social Security benefits) for a total annual income of $75,000.
Their resulting provisional income is $60,000, which is over the $44,000 income threshold for joint filers, and they could owe taxes on up to 85 percent of their Social Security benefits*.
The Benefits of Tax-Free Income
Having a source of tax-free assets such as a Roth IRA might help you avoid taxes on your Social Security benefits. Unlike tax-exempt bond interest, qualified Roth IRA distributions are not included in the formula for taxability of Social Security benefits.
This is because you don’t receive an income tax deduction on any contributions made to a Roth IRA. Also, there are no required minimum distributions (RMDs) from a Roth IRA throughout the lifetime of the original owner.
This is unlike traditional IRAs and employer-sponsored retirement plans where you must begin taking required minimum distributions once you reach age 72. These taxable distributions may increase your annual income and could affect the taxability of your Social Security benefits once they begin.
An Example of How a Roth IRA Can Reduce the Taxability of Your Social Security Benefits
Going back to the previous example we can illustrate how the use of a Roth IRA may help reduce (and possibly avoid) taxes on Social Security benefits. The only difference to their income in this new scenario is the couple has tax-free income from a Roth IRA instead of taxable income from a traditional IRA.
As a result, their Social Security benefits will not be taxed. Their Roth IRA income is excluded from the formula, and thus their provisional income is only $30,000, which is below the $32,000 threshold for taxing benefits*.
Once you understand how your Social Security benefits are taxed, you can begin exploring opportunities to potentially reduce the taxes you pay. Depending on your income and mix of assets, you may have the ability to better manage your tax liability in retirement.
*These hypothetical examples are used for illustrative purposes only. Actual results will vary.
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