Social Security Taxation

Okay, ladies and gentlemen, it is time now for Mr. Stillman's Opus with the one and only John Stillman, Rosewood Wealth Management. John, a lot of people are confused about Social Security and how it's taxed. A lot of people say, hey, I've already paid this money in, it shouldn't be taxed. And a lot of people basically are confused about the taxation of Social Security. Can you explain that whole thing? Well, so let's address what you just said, the idea that I was taxed on this money when I paid it.

And that's true. You still paid income taxes on the Medicare and Social Security withholdings that come out of your paycheck. So yes, you have paid taxes on that money. For most people, when you get your Social Security benefit, 85% of it is going to be taxable. So the idea there, essentially what the federal government is saying is that Social Security is that 85% of what's coming to you when you receive your Social Security, that represents your growth on what you've paid into the system. And then the 15% that's not taxed, that's what you paid in and were already taxed on and now it's just you getting your principal back.

Whether or not that math checks out, I think is dubious. But that's the story is that you're not being taxed on what you paid in when you get it back. You're only being taxed on the quote unquote growth.

Take that for what it's worth. Now, let's talk about that 85% because that's the important conversation to have here. Not everybody is going to have their Social Security be 85% taxable.

And again, let's clarify what we're talking about there. It's not that 85% of it will be taken away in taxes. It's just that 85% of your income.

Like make the math really easy. If your Social Security was $1,000 a month. Only $850 will go on your taxes as taxable income. So that's if you're in the 85% bracket. But it's important to understand there are three different brackets for Social Security. Most people, like I said, their Social Security is going to be 85% taxable. There is a group, however, where your Social Security will only be 50% taxable.

And then there's still a much smaller group, but a very happy group, where your Social Security is not taxable at all. And it's all dependent on how much other income you have. How much other income you're reporting.

And so, you know, anytime we do a class at the Friday Center, we do this little game where we create the same amount of income, but we do it in different ways. And we do it in a way where your Social Security is 50% or 85% or 0% taxable. That's going to change your actual net income. So the thing to understand is something called provisional income. So provisional income is essentially half of your Social Security. So let's write it all down. Again, make the math easy. Let's say your Social Security is $1,000 a month or $12,000 a year. Tracking with me?

I'm with you so far. So for the provisional income calculation, it's going to be half of your Social Security. So $6,000 is going to be going into that equation.

That makes sense. Added to that $6,000 is going to be all of your other income. So this is going to be earned income, any withdrawals from IRAs or 401ks. That's all going to be income. If you get interest from the bank for the 75 cents that you made on your $50,000 savings account, you got to add that in.

You'll get that $10.99. That interest counts. Any capital gains is going to go into this. So all those, and those you don't divide in half. That's just whatever the number is. Add that to half of your Social Security. That's going to tell us what your provisional income is. And whatever your provisional income is, that dictates how taxable your Social Security is.

I know it's all very confusing. The point that I want you to take away from this discussion is that there are things you can do if you have the right amount of money in the right places to get yourself into a position where your Social Security isn't taxable. Like, for instance, let's suppose that the only retirement savings you had were all in Roth IRAs.

Okay. Well, those withdrawals from Roth IRAs, as you know, aren't what, aren't taxable. They also don't count toward your provisional income. So if all, let's say you took $100,000 out of your Roth IRA, and then the only other income you had was Social Security, well, you would actually be in the 0% tax bracket. I like the sound of that. For Social Security.

Yeah. Because you would have no other taxable income. And so there are a lot of games we can play. In some cases, if folks have enough money in Roth IRAs, or just other non-taxable accounts, where we can take certain amounts of money out up to the threshold we come up just up to the ceiling, where if we spend a dollar more or not spend, but if we take a dollar more out of our account, suddenly our Social Security would be taxed. We want to figure out where that line is.

We want to go right up to that line. And then any additional income we take doesn't come from IRAs. It comes from Roth or other places where we can get the money tax free. So you say, well, all my money's in a 401k.

So what can I do about this? Well, if you're retiring tomorrow, there are limited things you can do about it, if we're being honest. But if you're younger, if you still have a ways to go, you could start doing all of your future savings in Roth. You could look at doing Roth conversions, and we have a whole other podcast about Roth conversions if you want to check that out. You could just save money in other ways that's not going to be quite so consequential from a tax standpoint down the road.

That's one thing you can do. And this we've been doing with a lot of clients recently is we basically play this every other year game where we say, all right, let's look at our tax brackets. And we've got the 10, the 12, the 22 percent bracket. And let's suppose that to live the life we want to live, we're going to be right in the middle of the 12 percent tax bracket. And if we wanted to withdraw another $20,000, we could do it and still be in the 12 percent bracket. So let's say that's 2018.

We could take another $20,000 out of IRAs that we don't actually need to live on. Still with me? Eyes not glazing over yet? No, not yet. I'm with you every step of the way. So let's take out that additional $20,000 this year. Pay the taxes on it this year in 2018. Okay. Okay. We didn't need it to spend this year, so we're going to park it in the bank.

All right. Well, now, next year, we have a $20,000 head start in terms of money that we need for our expenses. But we already paid taxes on it in 2018. It's counting toward our 2018 provisional income. We said, look, we're not going to get to the 0 percent tax bracket for 2018.

So we can take out more. It's fine. But by having that $20,000 head start, money that's already, I don't want to say laundered, because that sounds criminal.

Yeah, it does. We've already cleansed it. We've already paid the taxes on it. That's not going to count in 2019.

So that might be our first several months' worth of spending, that $20,000. Now, that reduces how much we have to take out of our IRAs in 2019. Well, now, we can do the 0 percent gain for 2019 and actually make it work. Okay, fast-forward to the next year. Okay, well, now, we have to take more out of the IRAs.

So you see, we can do this every other year. If we can take out enough in December of each year to tide us over for part of the next year, then we can make our Social Security not taxable the following year. And that's how you start to see good tax planning really affect your retirement plan. We could be talking about the difference of $3,000, $4,000, $5,000 a year saved in taxes just by thinking through this ahead of time. Well, that's a complicated issue, but you make it simple.

You make it easy to understand, and you can certainly help people figure out how to do that for themselves. Well, a lot of people say, why isn't my CPA helping me with this? For the most part, this is not what CPAs do. CPAs are looking back at what happened the last year and making sure you fill in the right boxes to make sure that you're paying the taxes that you owe for the previous year.

And they may have some suggestions moving forward of, all right, why don't you think about this for next year? But more often than not, your CPA isn't doing this kind of proactive planning when it comes to where you're taking your income from in a given year. Most financial advisors aren't doing it either. And I'm convinced that if more financial advisors and CPAs talk to each other about their current clients, you'd actually see some progress on here.

And that's why in so many cases, I'm pretty dogmatic about the fact that, yeah, I want to talk to your CPA. I want to do some planning on this to be sure that we're not missing any opportunities. And it really is a missed opportunity for a lot of people. And like I said, we have several folks. It's not going to work for everybody. If you want to spend $150,000 a year, okay, there's nothing we can do to get you in the 0% tax bracket. But if you're kind of in that in-between realm and we can do it every other year, it really does make a difference. All right. Well, if you want to find out more about this, if you'd like to do this, then get in touch with John Stillman at Rosewood Wealth Management. John, you've managed to hit all the right notes. And that's why we call this Mr. Stillman's Opus.