You Don’t Believe Me Do You?
And that’s okay. When I tell people that having “tax-free” income can make their Social Security benefits taxable they typically scoff. But, if they take a look at the tax code they’ll find out that oh yes indeed, “tax-free” interest can in fact subject your Social Security benefits to taxation.
I’m in the final stages of finishing up my second book. This one is going to be on why Roth IRAs are so incredibly valuable. Initially, I was going to title it “21 Reasons You NEED A Roth” but I’m not sure that’s what I want to go with If you have thoughts I’d love to hear them.
Anyway, the premise is that people make the critical mistake of just comparing a Roth vs. a Tax Deferred account by using a “tax rate now vs. tax rate in the future” analysis. Don’t do that. Way too much goes into the tax rate in the future part of the analysis. I’ll just give you a glimpse here.
Municipal bonds interest, aka ‘tax free’ interest, is included in the calculation of how your Social Security benefits are taxed. Roth IRA distributions are not.
Taxation on Social Security benefits is a very odd formula. But here it is:
|Tax Filing Status||Provisional Income||Social Security Taxation|
Single or head of household
|Less than $25,000||0%|
|$25,000 – $34,000||Up to 50%|
|More than $34,000||Up to 85%|
|Less than $32,000||0%|
|$32,000 – $44,000||Up to 50%|
|More than $44,000||Up to 85%|
Let’s just put it this way, EVERYTHING is based on that middle column called PROVISIONAL INCOME.
But what exactly is PROVISIONAL INCOME. Can’t find it in the tax code, on the IRS website or even SSA.gov. SSA.gov sometimes calls it “Combined Income”. But very rarely is that term used elsewhere. So, we in the financial planning business, say “Provisional Income”.
How you calculate your Provisional Income is take 1/2 of all your Social Security benefits and add to ALL your other income…to include TAX EXEMPT interest. Once you have that number you run the numbers in the formula above and you get how much of your Social Security will be taxed.
Add that number to your Gross Income (in this case is income MINUS tax exempt income) and you have your AGI.
So, what the heck does all this mean, you ask?
Let’s take a retired couple in their 60s, John and Judy who are living large on $100k a year income. That income derives from $55k of tax free income and $45k of Social Security.
Take that $55k of tax free interest and add to it 1/2 of their Social Security benefit and their provisional income is $77,500.
To find out how much of their Social Security benefit is taxed we just run the numbers.
|$77,500 in Provisional Income|
|Income Range||% Taxable||Taxable|
In this case, because their income consisted solely of tax exempt interest and their Social Security benefit, their Adjusted Gross Income will be the amount of their Social Security benefit that is taxed, $34,475.
Not a huge tax burden, after you take out their $26,600 in standard deductions if they are over 65 years old, mind you. But roughly $1k tax nonetheless.
Now if we replaced the tax exempt interest with ROTH IRA distributions. Their Provisional Income would be all of $22,500 meaning NONE of their Social Security is taxed, meaning they pay NO tax. Because Roth distributions are not included in the Provisional Income calculations. But tax free interest is.
So, as you can see, ‘tax-free’ interest can indeed cause you to pay taxes. Be advised you won’t pay INCOME taxes on your tax-exempt interest but you can certainly be thrown into a bracket which forces you to pay tax on Social Security.
Oh, I know, “Josh, $1k in taxes isn’t that bad on $100k income. What’s the big deal?”
Don’t worry, my friends, the fun has just begun. Wait until you see what happens to a surviving spouse.
Did I do a video on this??? Of course. Click Here.