Tax Tip: How Social Security and Railroad Retirement Is Taxed

Editor's Note: This article is part of our 2013 Tax Tips series. Robert Flach is an expert with almost 40 years of experience as a tax professional and also blogs as The Wandering Tax Pro.

NEW YORK (MainStreet)—All too often during the tax filing season my explanatory memo to clients includes the following statement:

"Because of the way Social Security benefits are taxed, for every additional dollar you receive, you are taxed on $1.85!"

The amount of Social Security or Railroad Retirement benefits that are subject to federal income tax depends on the amount of your other income - both taxable and tax-exempt.

The calculation of taxable benefits starts with one-half of your gross Social Security or Railroad Retirement benefits (from Box 5 of Form SSA-1099 or RRB-1099) – combined if filing a joint return.

To this number you add all other taxable income (Form 1040 Lines 7, 8a, 9a, 10-14, 15b, 16b, 17-19, 21).

Next you add the amount of tax-exempt interest reported on Box 8b of Form 1040. While municipal bond interest is exempt from federal income taxation, it is included in the calculation of taxable SS or RR benefits – so up to 85% of tax-exempt municipal interest could be subject to federal income tax.

From the total of these three amounts you subtract the total "adjustments to income" from Form 1040 line 23 – 32 plus any write-in adjustments included in Line 36. Deductions for student loan interest, tuition and fees, and domestic production activities, the adjustments reported on Form 1040 lines 33, 34, and 35, are not allowed in calculating taxable benefits.

If this amount - one-half of benefits plus other taxable income plus tax-exempt interest less most adjustments to income - exceeds $25,000, or $32,000 for married couples filing a joint return, up to 50% of your benefits will be taxed. If the excess exceeds $34,000 or $44,000 respectively, up to 85% of your benefits will be taxed.

If you are filing as Married Filing Separately and you lived with your spouse at any time during the year, you will automatically pay tax on 85% of your Social Security or Railroad Retirement benefits. If you file separately and you and your spouse lived apart for the entire year you calculate the taxable benefit as if you are a Single individual.

So you can see how an additional $1.00 of taxable income can end up being effectively taxed as $1.50 or $1.85, and an additional $1.00 of otherwise tax-exempt income can be taxed as 50 cents or 85 cents.

To look at this another way – a person in the 15% tax bracket would pay $28.00, and not $15.00, on an additional $100.00 of income, and a person in the 25% bracket would pay $46.00.

The $25,000, $34,000, $32,000 and $44,000 figures have never been indexed for inflation.

There comes a point when your level of income is such that you are being taxed on the maximum 85% of your gross benefits. In such a case, additional income does not increase your taxable Social Security or Railroad Retirement – and $1.00 more is taxed as $1.00.

Let us look at two situations that highlight the inequity of this method of calculating taxable benefits.

(1) Most of my clients are from New Jersey. Many of my senior citizen clients take advantage of the free, or almost free, buses to Atlantic City on a regular basis. I am reminded of the little old Irish man who, after picking up his finished return, announced – "I just got my Social Security check. I am off to Atlantic City." Occasionally these clients receive a Form 1099-G for winnings from the slot machines.

Case in point: A client in the 15% tax bracket, who is collecting Social Security, reports $2,500 in gambling winnings on Page 1 of Form 1040. The taxpayer is able to itemize and get a full tax benefit for deducting $2,500 in losses, even though the total gambling losses for the year from all sources exceeded $2,500 – your losses are deductible only to the extent of winnings. The net results of the gambling activity for the year was "0" (actually less than 0) – so it would appear there is no income tax on the winnings. But because of the client's level of income, $2,125 more of the Social Security benefits received is taxed. So $0 of net gambling winnings cost $319 in federal income tax!

(2) We are told that the maximum tax on qualified dividends, capital gain distributions, and long-term capital gains is either 0% or 15%, depending on one's level of income. However a net long-term capital gain of $2,500, or additional $2,500 in qualified dividends, for a Social Security recipient in the 15% tax bracket could cost the same $319 in federal income taxes – so the tax rate on the gain is about 12.75% and not 0%. Or 21.25% and not 15% for someone in the 25% bracket.

So what should a Social Security or Railroad Retirement recipient do? Consult a tax professional before year end!

--Written by Robert D. Flach for MainStreet

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