Why don't I see exactly 50% or 85% of Social Security benefits being taxed?

The taxability of Social Security has a meaningful effect on tax estimates and can be a key part of tax-smart distribution planning. So, it's important to get those estimates right. For example, if a plan simply assumed that fully 85% of benefits would be taxed every year of the plan, that plan would likely be far from the truth for many plans.

The amount of a household's Social Security benefits that is taxed in any given year depends on the total benefits combined with "other income". (Only certain types of income are included in "other income".) Anywhere between 0% and 85% of benefits may be taxable. At certain income levels, a maximum of 50% of benefits is taxable; however, in no case will more than 85% be taxable.

However, rather than a system that simply taxes 0%, 50%, or 85% of benefits, Social Security taxation is actually a sliding scale with caps. For example, below we see the taxability amount for different benefit amounts as the total income rises. Notice that this graph is not a stair-step from 0% to 50% to 85%. Instead, all lines begin at 0% and, after a point, start rising diagonally. The lowest benefit amount ($6,000) finds a plateau at 50% before again rising. All lines cap out at 85%.

Notice that all of the diagonal lines in this graph have a "kink" in them. That's where 50% taxability moves to 85%. Even cases that fall within the 85% taxability bracket could be considered part of the taxable amount at the 50% bracket. You can think of this like progressive tax brackets. For example, let's assume a household has $100k in Social Security benefits and $60,000 in other income in a given year. Social Security taxability depends in part on something called "combined income", which is 50% of benefits + "other income". The "combined income" for this example is $100k * 50% + $60k = $110k. Since this is above the $44,000 85% taxability threshold for a couple, one might think that 85% of the Social Security benefits will be taxed. But 85% is just the maximum taxable amount. The actual taxable amount is calculated in a more complex way that takes into account the 50% taxability bracket.

In this example, only $62,100, or 62.1% of the total Social Security benefits, will be subject to taxation. This is 50% of the combined income that falls between the 50% and 85% bracket thresholds, plus 85% of the combined income that exceeds the top threshold. Since that is less than 85% of total Social Security benefits, that lower amount is taxable.

When clients hear about 0%, 50%, or 85% taxability of Social Security, they may expect a much simpler system than this, and they may be confused to see anywhere from 0% to 85% of their benefits being taxed (not just a flat 0%, 50%, or 85%).

Advisors may also be accustomed to using planning software that requires them to enter the taxability level of Social Security as an input assumption for the plan (often applying that assumption to the entire plan). However, Income Lab actually estimates Social Security taxability in each year of the plan. That means that (a) the amount taxed will not necessarily be a flat 0%, 50%, or 85% of benefits in any given year of a plan, because actual benefit taxability is more complex than this, and (b) benefit taxability can vary year to year due to changes in the make-up of income in those years (e.g., IRA distributions vs Roth distributions).

It's also worth noting that Social Security taxability thresholds are not adjusted for inflation over time. This means that, in a typical inflationary environment, more and more of a household's benefits will be taxable as time goes on, all else being equal. This means that, even if a plan were straightforward, with equal amounts of Social Security benefits and "other income" in each year, the amount of taxable benefits can increase over time, and taxability brackets can even shift from 50% to 85%. That's because while Social Security benefits see cost-of-living adjustments, taxability thresholds do not.

This adds additional complexity to estimates and calculations. This is another reason tax-smart distribution planning is best done by taking all of the particulars of a plan into account.