Social Security: Exactly How Taxes on Benefits Impact Your Retirement | Provisional Income EXPLAINED

Hey guys, what's up? I'm Erin and welcome back to the channel. Should Americans be taxed on their hard-earned Social Security benefits? It's a question that has sparked heated debate, especially during our recent political campaign. But here's the reality. Depending on your income, you could be taxed. Let's break down how Social Security benefits are taxed, why the system exists, and what it means for your retirement. When it comes to Social Security benefits, they aren't taxed exactly like traditional When it comes to Social Security benefits, we look at provisional income. The IRS uses provisional income to determine if and how much of your Social Security benefits are taxable. This approach ensures benefits are taxed only when total income exceeds specific thresholds. At first, you might wonder why provisional income even exists. Perhaps it's to add complexity to an already complex system. Lawmakers, on the other hand, are probably going to argue it's about fairness and equality. When Social Security benefits were first introduced, they weren't taxable. But in 1983, taxation on benefits was introduced. The whole idea of using a provisional income is that it aligns with Social Security's progressive nature, which is the whole foundation of the Social Security system. The idea that those with lower incomes wouldn't have to pay tax on their benefits, and those with higher incomes might have to pay taxes on up to 85% of their benefits. The Social Security system aims for fairness, to prevent undue financial burdens for those who are considered lower income earners, and then prevent excess benefits for those who are considered higher income earners. The provisional income formula looks like this. Your adjusted gross income, which is incomes from wages, dividend incomes, and any other taxable income sources. Non-taxable interests would include tax-exempt incomes, like income on a municipal bond. Including them in the calculation gives Social Security a complete view of a household's financial situation when determining taxability. And finally, Social Security benefits. And only 50% of an individual's or household's Social Security benefits are included in this calculation. The reason only 50% of Social Security benefits are included in this calculation, rather than 100%, lies in how Social Security is funded. And again, the idea of fairness. Social Security is funded through payroll deductions by employees, as well as an employer match. For those who are self-employed, they pay both the employee side and the employer side. The employees pay 6.2% of gross wages, and the employers match the same 6.2%. Because employers fund 50% of payroll taxes, the IRS treats only 50% of Social Security contributions as coming from your contributions. So by looking at only 50%, they avoid double taxation on the employer's contributions. Policymakers wanted to maintain the idea that only the equivalent of what would be the personal contributions would be subject to tax, since they're contributed to the system pre-tax. Again, keep in mind that the whole basis of this system is striving for fairness. Including 50% instead of 100% in the provisional income calculation ensures that low- and middle-income retirees aren't unfairly taxed on their benefits, as Social Security was designed to be a safety net for retirees. Often, it is lower-income earners who are more heavily reliant on Social Security during their retirement years, and taxing these benefits excessively could create undue financial hardship for this group. Higher-income individuals may have up to 85% of their benefits taxed. So let's run an example and see how this calculation would look for a couple married and filing jointly. In order to run this calculation, we need an adjusted gross income, any non-taxable income sources excluding Roths Roths are not included in this calculation, as well as the household Social Security benefits. Let's say this household has an adjusted gross income from a traditional 401k of $45,000 for the year. We're not going to include any non-taxable income, assuming they don't have any municipal bonds for the sake of simplicity. And we'll assume the household has a Social Security benefit of $30,000 for the year. So all in all, this household would have a provisional income of $60,000. Next, we have to consider what the Social Security income thresholds are for taxation. For those married and filing jointly, household incomes between $32,000 and $44,000, up to 50% of Social Security benefits would be subject to tax at the federal level. Incomes beyond $44,000, up to 85% of benefits could be taxed. I did recently do a video talking about these income thresholds. And one of the glaringly obvious points about these income thresholds is that they're not indexed for inflation. They were introduced back in 1983 and haven't been adjusted since. So if they look low, it's because they are. So in this situation, we have a household that has a provisional income of $60,000, which is beyond the $44,000 limit, making it so that up to 85% of their benefits from Social Security could be subject to tax at the federal level. Let's break down the calculation and see what it actually looks like. The first step is we look at the portion of their Social Security income that would be taxable at 50%. So this is the income above and up to the 50% tax bracket threshold. In this case, it's $12,000. We multiply that by 50% and that gives us $6,000. Next, because this household has an income that surpasses the second threshold of $44,000, we must complete a second step for benefits taxable at 85%. Taking our household income minus this upper threshold, we get $16,000 and we multiply that by 85% and that gives us $13,600. Now we need to combine these two numbers and adding the two taxable portions from both stages, you get $19,600. Keep in mind, the law caps the total taxable portion of benefits at 85%. Now we do a sort of checks and balances calculation. We take the household's annual income from Social Security and multiply that by 85% and in this case, we get $25,500. Then we look at our two numbers and we choose the lesser of the two. In this situation, the $19,600 is the amount that would be subject to income tax. If the number that we got when we took the household Social Security income and multiplied it by 85% had been lesser of the two numbers, we would have used that number. It is always the lesser of the two. Keep in mind that everyone's situation is different. The provisional income for any given household is going to be different. It depends on if they exceed these thresholds and by how much. Now if we want a general rule of thumb for high income earners, let's say you're a couple married and filing jointly and you have a household income that far and away exceeds this threshold of $44,000 a year or you're a single filer and you have an income that far and away exceeds $34,000 a year. You could take your benefits from Social Security, multiply by 85%, and that will give you a good rough estimate of the portion of benefits that would be subject to taxes at the federal level. Now keep in mind, this is not an exact science. It will not work in every situation, but it does give you a good rough estimate. Skipping the steps or using this simplified version can result in incorrect calculations. Now let's return to the couple from our example. We know the amount of their Social Security benefits that are now subject to taxes at the federal level. Let's calculate what their federal tax burden is. Their income subject to federal taxes in this situation is $64,600. Remember that the $45,000 withdrawal from a traditional 401k is treated as ordinary income. We subtract the standard deduction and apply the income tax brackets, and this couple has a federal income tax bill of roughly $3,784. Two things worth mentioning. First, if this couple had made a withdrawal from, say, a Roth account rather than a traditional account, they would not have to pay income taxes on that withdrawal. And then if we were in this situation, with this income level from Social Security applying the standard deduction, this couple would not face any taxes on their Social Security benefits in that year. Also, 41 states don't tax Social Security benefits. Nine states do. So how they're treated on the state level does vary by state. Taxing Social Security benefits can feel like navigating a maze, but understanding the provisional income thresholds and how the calculations work can empower you to make better financial decisions. While the system strives for fairness, it's clear that there's room for improvement when we consider that these income thresholds have not been adjusted for decades. So what are your thoughts on how these Social Security benefits end up being taxed? Share them in a comment down below. I post new videos every single week. If you got anything at all out of this one, please give it a like. If you're new here, please consider subscribing. Or if you know of someone who might get something out of this type of content, please consider sharing. I'll see you soon. Bye.