A man who had retired at the end of 2020 recently reached out to me. With newfound time on his hands, he decided to try free tax software packages and do his own taxes this year. The surprise? His Social Security benefits pushed him into a higher-than-expected tax bracket. "What's up with that?" he wanted to know.
The Caller's Income Situation
"Barry" waited until 70 to get his maximum Social Security benefit. His wife, "Lydia," was a homemaker. Born in 1952, he was grandfathered into the former "file and suspend" strategy.
They took advantage of that strategy so Lydia's spousal benefits started several years ago. Up to 2021, their income had been from W-2 wages, Lydia's Social Security, and some interest and dividends.
Tax year 2021 was their first year of full retirement income.
Components of Retiree Income
Barry saw firsthand exactly what is considered "income" as a retiree. They now have a hodge-podge of income sources. Looking at the front of IRS Form 1040-SR, Barry noted their income was from:
- Taxable interest
- Ordinary dividends
- IRA distributions from Lydia's and his IRAs
- Social Security benefits for both of them
- Capital gains
He confirmed no pension or annuity income. They thought about renting out their vacation home, but rental income also would be taxable income.
Not All Social Security Income Is Taxable
Social Security benefits become taxable income when "combined" income exceeds $25,000 for a single filer and $32,000 for a married couple filing jointly. Either 50% or 85% of Social Security benefits can be pulled in as ordinary income.
Combined income is determined on a worksheet in the 1040 instruction booklet. At a high level, a client must combine various parts of income from their 1040 in a creative way:
- 50% of total Social Security gross benefits, plus
- All other income on lines 2b – 5b, 7, 8, plus
- Tax-exempt interest as reported on line 2a, plus
- Certain adjustments from Schedule 1 that reduce income.
The sum of the parts is compared to threshold amounts in a series of steps on the worksheet. The end result is the dollar amount of Social Security that will be includable as income on line 6b of the 1040.
