How to Gauge Benefits Tax

How-to-Gauge-Benefits-Tax

Some people who begin claiming Social Security benefits are surprised to find out they’re taxed by the federal government on the amounts they receive. If you’re wondering whether you’ll be taxed on your Social Security benefits, the answer is: It depends. Here’s what to know and how to gauge benefits tax.

The taxation of Social Security benefits depends on your other income. If your income is high enough, then between 50 percent and 85 percent of your benefits could be taxed. (This doesn’t mean you pay 85 percent of your benefits back to the federal government in taxes. It merely means that you’d include 85 percent of them in your income subject to your regular tax rates.)

Formulas and Fine Print

To determine how much of your benefits are taxed, first calculate your other income, including certain items otherwise excluded for tax purposes (for example, tax-exempt interest). Add to that the income of your spouse if you file a joint tax return. To this, add half of the Social Security benefits you and your spouse received during the year. The figure you come up with is your total income plus half of your benefits. Now apply the following rules:

  1. If your income plus half your benefits isn’t above $32,000 ($25,000 for single taxpayers), none of your benefits are taxed.
  2. If your income plus half your benefits exceeds $32,000 but isn’t more than $44,000, you will be taxed on one half of the excess over $32,000, or one half of the benefits, whichever is lower.

Here is an example to illustrate:

Let’s say you and your spouse have $20,000 in taxable dividends, $2,400 of tax-exempt interest, and combined Social Security benefits of $21,000. So, your income plus half your benefits is $32,900 ($20,000 + $2,400 + half of $21,000). You must include $450 of the benefits in gross income (½ [$32,900 − $32,000]).

(If your combined Social Security benefits were $5,000, and your income plus half your benefits were $40,000, you would include $2,500 of the benefits in income: ½ [$40,000 − $32,000] equals $4,000, but half the $5,000 of benefits [$2,500] is lower, and the lower figure is used.)

Note: If you aren’t paying tax on your Social Security benefits now because your income is below the floor, or you’re paying tax on only 50 percent of those benefits, an unplanned increase in your income can have a triple tax cost. You’ll have to pay tax on the additional income. You’ll have to pay tax on (or on more of) your Social Security benefits (since the higher your income the more of your Social Security benefits are taxed). And you may get pushed into a higher marginal tax bracket.

For example, this situation might arise if you receive a large distribution from an IRA during the year or if you have large capital gains. Careful planning might avoid this negative tax result. You might be able to spread the additional income over more than one year, or liquidate assets other than an IRA account, such as stock showing only a small gain or stock with gain that can be offset by a capital loss on other shares.

Stay Ahead of the Game

If you know your Social Security benefits will be taxed, you can voluntarily arrange to have the tax withheld from the payments by filing a Form W-4V. Otherwise, you may have to make quarterly estimated tax payments. Keep in mind that most states do not tax Social Security benefits, but 12 states do tax them. Contact the experienced professionals at Ramsay & Associates for assistance on how to gauge benefits tax or for more information on social security benefits.

About the author

Brady is the owner of Ramsay & Associates. He specializes in financial statement preparation and personal, fiduciary and corporate tax and accounting.

His professional experience includes seven years' experience for local and national CPA firms before joining Ramsay & Associates in 2006.

He has a Bachelor of Accounting degree from the University of Minnesota Duluth. He is a Certified Public Accountant, a member of the Minnesota Society of CPA's, an Eagle Scout, as well as an active volunteer in the community.

Is Now a Good Time for a Roth Conversion?

Is-Now-a-Good-Time-for-a-Roth-Conversion

The downturn in the stock market may have caused the value of your retirement account to decrease. But if you have a traditional IRA, this decline may provide a valuable opportunity: It may allow you to convert your traditional IRA to a Roth IRA at a lower tax cost. Keep reading to learn more.

Traditional vs. Roth: What Sets Them Apart?

Here’s what makes a traditional IRA different from a Roth IRA:

Traditional IRA. Contributions to a traditional IRA may be deductible, depending on your modified adjusted gross income (MAGI) and whether you (or your spouse) participate in a qualified retirement plan, such as a 401(k). Funds in the account can grow tax deferred.

On the downside, you generally must pay income tax on withdrawals. In addition, you’ll face a penalty if you withdraw funds before age 59½ — unless you qualify for a handful of exceptions — and you’ll face an even larger penalty if you don’t take your required minimum distributions (RMDs) after age 72.

Roth IRA. Roth IRA contributions are never deductible. But withdrawals — including earnings — are tax free as long as you’re age 59½ or older and the account has been open at least five years. In addition, you’re allowed to withdraw contributions at any time tax- and penalty-free. You also don’t have to begin taking RMDs after you reach age 72.

However, the ability to contribute to a Roth IRA is subject to limits based on your MAGI. Fortunately, no matter how high your income, you’re eligible to convert a traditional IRA to a Roth. The catch? You’ll have to pay income tax on the amount converted.

Minimize Your Tax Hit?

This is where the “benefit” of a stock market downturn comes in. If your traditional IRA has lost value, converting to a Roth now rather than later will minimize your tax hit. Plus, you’ll avoid tax on future appreciation when the market goes back up.

It’s important to think through the details before you convert. Here are some of the issues to consider when deciding whether to make a conversion:

Having enough money to pay the tax bill. If you don’t have the cash on hand to cover the taxes owed on the conversion, you may have to dip into your retirement funds. This will erode your nest egg. The more money you convert and the higher your tax bracket, the bigger the tax hit.

Your retirement plans. Your stage of life may also affect your decision. Typically, you wouldn’t convert a traditional IRA to a Roth IRA if you expect to retire soon and start drawing down on the account right away. Usually, the goal is to allow the funds to grow and compound over time without any tax erosion.

Keep in mind that converting a traditional IRA to a Roth isn’t an all-or-nothing deal. You can convert as much or as little of the money from your traditional IRA account as you like. So, you might decide to gradually convert your account to spread out the tax hit over several years.

Ask the Financial Planning Pros

So, is now a good time for a Roth conversion? It could be. There are also other issues that need to be considered before executing a Roth IRA conversion. If this sounds like something you’re interested in, contact the financial planning pros at Ramsay & Associates. We can answer your questions and discuss whether a conversion is right for you.

About the author

Brady is the owner of Ramsay & Associates. He specializes in financial statement preparation and personal, fiduciary and corporate tax and accounting.

His professional experience includes seven years' experience for local and national CPA firms before joining Ramsay & Associates in 2006.

He has a Bachelor of Accounting degree from the University of Minnesota Duluth. He is a Certified Public Accountant, a member of the Minnesota Society of CPA's, an Eagle Scout, as well as an active volunteer in the community.