When is Social Security taxable?

In 2014, more than 59 million Americans will receive a total of over $860 billion in Social Security benefits. Given that Social Security taxes on their wage and salary income have gone toward funding the program, many recipients never even think about the possibility that lawmakers might have made Social Security taxable. Yet for an increasing number of beneficiaries, Social Security is taxable, and knowing the rules governing whether you'll have to pay income tax on your benefits is important in assessing exactly how much after-tax money you'll have to provide financial support after you retire.

Who made Social Security taxable?

Throughout the early decades of the Social Security program, benefits were explicitly excluded from federal income taxes. Early on, the rationale for not taxing Social Security benefits was that because wages had been subject to taxation, the benefits that stemmed from payroll taxes on those wages should be treated as after-tax income and therefore shouldn't increase taxable income in retirement.

Over the years, though, the thinking on benefits evolved. With private pensions, worker contributions make part of their eventual benefits tax-free, but any growth in those contributions -- whether due to investment gains or employer contributions -- makes the remainder of benefit payments taxable. As the SSA describes it, about 15% of the average Social Security recipient's benefits are directly paid by payroll taxes, leaving as much as 85% to come from other sources and therefore be more justifiably taxable under generally accepted tax principles.

In the late 1970s, a Social Security Advisory Council was formed to look at financing for Social Security. The suggestion that some Social Security benefits should be made taxable arose there, and the so-called Greenspan Commission later specifically suggested that 50% of benefits above certain income limits be subject to tax. By the time of the 1983 Social Security Amendments, this suggestion had taken effect: Single workers with incomes of more than $25,000 and joint filers earning more than $32,000 faced taxes on up to half of their benefits.

A decade later, lawmakers added a second, higher tier of taxation. For singles earning more than $34,000 and joint filers with income above $44,000, as much as 85% of their Social Security benefits could be subject to tax.

Will your Social Security be taxable?

As simple as those threshold amounts sound, the actual calculation of how much of your Social Security benefits will be taxable is complex. The first step is to add up all your income, including what would ordinarily be tax-exempt income from municipal bond interest, and then add in one-half of your Social Security benefits for the year. If you're over the $25,000 or $32,000 initial thresholds, then some of your benefits might be taxable.

From there, though, you have to use a special Social Security Benefits Worksheet (link opens PDF) from the IRS. But the general idea is that for every dollar of extra income you earn above the lower threshold, $0.50 of your Social Security benefits will be subject to tax. Above the upper threshold, each extra dollar of income adds $0.85 to the total benefits that the IRS will tax. That's less draconian than the mistaken belief some people have that as soon as you earn the first dollar above those thresholds, 50% or 85% of your entire benefits are automatically taxed.

For instance, if you're single and received $12,000 in Social Security benefits and $20,000 in other income, then your total income for these purposes would be $20,000 plus half of $12,000, or $26,000. That's $1,000 above the lower threshold. Half of that amount is $500, and because your actual benefits are more than $500, you'd pay taxes on $500 of what you got from Social Security.

Many see Social Security taxation as unfair, especially given that they've already paid payroll taxes on the income they see as having generated their retirement benefits. Nevertheless, knowing when Social Security is taxable can help you plan more effectively for your future finances after you retire.

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