How Are Social Security Benefits Taxed?
It is surprisingly complicated to ascertain the amount of Social Security benefits that your clients must include in their taxable income. The good news is that at least 15 percent of Social Security retirement benefits are excluded from tax, and in some cases, Social Security benefits are totally exempt. In addition, clients who are able to lower their adjusted gross income (e.g., by taking tax-free Roth or health savings account (HAS) distributions instead of taxable retirement distributions) may decrease or eliminate the amount of their Social Security income that is subject to taxation. The bad news is that tax-exempt bonds and harvested capital gains lose some of their luster if the taxation of Social Security benefits is a concern for your client.
To provide useful advice to clients who must include Social Security benefits in their taxable income, it might be prudent to suggest that the client have federal income tax withheld from their benefits. A Voluntary Withholding Request is done using Form W-4V. An alternative is for the client to file quarterly estimated taxes or to “over-withhold” taxes from other sources of income to make up for any shortfall caused by taxes owed on Social Security and to avoid tax penalties that apply when the client withholds too little in taxes.
Planners can provide added value to their clients by understanding how Social Security benefits are taxed and by using that knowledge to implement proper planning for their clients.