Key Points
Retirees need to understand how Social Security benefits work.
Some seniors are caught off guard by a key rule each year.
This rule works differently than many other parts of the Social Security program, and it costs retirees money.
For millions of retirees relying on Social Security, understanding the rules of this popular benefits program is crucial. Unfortunately, some rules are confusing and work differently than you might expect.
In fact, there’s one specific regulation that surprises retirees each year — and it could cost them money. Here’s what the rule is, along with some details on why it catches so many seniors off guard.
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Retirees don’t expect this Social Security rule
The Social Security rule that catches many seniors by surprise has to do with when taxes are charged on benefits. And the issue is that, unlike many other rules regulating the program, the threshold is not indexed to inflation.
Social Security benefits were originally not taxed at the federal level. That changed in the 1980s and 1990s, when lawmakers enacted reforms to shore up the program’s finances.
When the rules were put into place, retirees began to owe tax on part of their benefits once their provisional income exceeded $25,000 for single tax filers and $32,000 for married joint tax filers. Provisional income is half of all Social Security benefits, all taxable, and some non-taxable income. Specifically, this is how it works:
Single filers with provisional income between $25,000 and $34,000 owe tax on up to 50% of benefits. With income above $34,000, they owe tax on up to 85%.
Married joint filers with provisional incomes between $32,000 and $44,000 owe tax on up to 50% of benefits. With income above $44,000, they owe tax on up to 85%.
At the time these rule changes were put into place, fewer than 10% of retirees owed tax on their benefits, according to the Senior Citizens League. Now, around half of all retirees do, and the number is growing each year. This catches many seniors by surprise.
An unexpected tax bill could affect your retirement plans
Far too many seniors don’t take this tax rule into account when doing their retirement planning because it’s natural to assume that the thresholds for when benefits become taxable would change over time.
After all, automatic inflation adjustments are a key part of Social Security, with Social Security cost-of-living adjustments happening automatically most years, as well as with annual changes to the amount you can earn while working under full retirement age before benefits are affected.
But, even though retirees generally have a little more income each year as a result of normal wage growth and periodic COLAs, the tax thresholds don’t change. Seniors need to plan and prepare for this because finding out that your latest COLA or a slightly larger 401(k) withdrawal suddenly creates new obligations to the IRS can be an upsetting surprise.
For future retirees who don’t want to worry about this issue, there’s also the option to invest in Roth accounts, like a Roth 401(k) or Roth IRA, as distributions from these accounts won’t count toward the $25,000 or $32,000 limits. Working with a financial advisor to optimize retirement investment accounts and tax strategies could be a good way to make an informed choice.
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