Taxing Problem: Working and Collecting Social Security

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This column is part of a series of special reports from MarketWatch. The reports are based on live panel discussions hosted by senior columnists and editors from MarketWatch with guest panelists who are experts in the field of retirement planning and benefits. This segment of Retirement Adviser offers the highlights from a roundtable discussion held earlier this month in Boston, hosted by Robert Powell.

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When it comes to retirement, the average American age 65 and older generates nearly two-thirds of their total income from a combination of earned income and Social Security, with the rest coming from pensions and personal assets.

But despite the fact that millions are earning income and collecting at the same time, there's still plenty of confusion over how Uncle Sam goes about taxing and reducing Social Security benefits for workers. Consider, for instance, some of the reasons why it can be confusing:

First, if you retire before the normal retirement age and start collecting Social Security benefits early, your benefits are reduced not only for starting early, but also as your earnings rise. In fact, if you work and collect before the so-called full retirement age, you'll lose $1 of Social Security benefit for every $2 earned over $14,160 in 2011.

Second, in the year that you reach full retirement age, your benefits are reduced $1 for every $3 earned over $37,680 in 2011, or least that's the case until the month you reach full retirement age.

Finally, once you're at full retirement age, your benefits are not reduced, but as much as 85% of the benefits could be taxed if your income is above a certain amount.

According to the Social Security website, if you file a federal tax return as an individual and your combined income is between $25,000 and $34,000, you may have to pay income tax on up to 50% of your benefits. And if your combined income is more than $34,000, up to 85% of your benefits may be taxable. If you file a joint return, and you and your spouse have a combined income that is between $32,000 and $44,000, you may have to pay income tax on up to 50% of your benefits. And if your combined income is more than $44,000, up to 85% of your benefits may be taxable. If you are married and file a separate tax return, you probably will pay taxes on your benefits.

Even though all this might be confusing, there are some ways to increase your after-tax income from all your sources of income -- be it earned income, Social Security, dividends, interest income, capital gains, pension income and the like. What's more, there are some ways to think differently about the interaction between earned income and Social Security benefits.

At a recent MarketWatch roundtable discussion, two of the nations' top retirement-planning experts offered tactics to consider to when deciding whether and how much to work in retirement, as well as whether and when to start taking Social Security benefits.

Never a net negative to work and to collect

"I find there are a lot of myths and misconceptions out there about what it means to have earned income still in retirement, and what the tax implications are," said Michael Kitces, who is the editor and publisher of The Kitces Report as well as director of research at Pinnacle Advisory Group. "And frankly, I've never seen a situation where there was actually a net loss for working. There are a lot of folks who have this idea of 'I can't work in retirement because it may make my taxes go up and I may have more of my Social Security taxed or I may have to impact IRAs or do something else, so maybe I won't work.'"

And so the first thing that you have to realize, according to Kitces, is that you never get a net negative for working and collecting Social Security. "If you work and you bring additional earned income into the household, there is more money there," he said. "You don't get to keep all of it, Uncle Sam will take a piece, and you may impact a couple other parts of the retirement pie as well, but it's never a net negative."

Elaine Floyd, Certified Financial Planner, director of retirement and financial life planning at Horsesmouth, and author of "135 Social Security Questions Answered: What Savvy Advisors Need to Know, as well as The Financial Advisor's Guide to Savvy Social Security Planning," agreed.

"It always pays to work," said Floyd. "People are under the impression that if they earn more than $14,160 a year that they're going to be penalized. Well, it's really important, when you get into your 60s, to understand what the earnings test really is."

For starters, if you're over full retirement age, there is no earnings test, Floyd said. The earnings test comes into play only if you apply for Social Security before you turn full retirement age. And for those who have to deal with the earnings test, where for every two dollars you make over $14,160, one dollar of your Social Security will be withheld, it's important to understand what happens to that amount that's withheld, she said.

"Some people have heard that you get it back," she said. "You don't really get it back. You do, however, get a credit, and it's important to understand that credit for the actuarial reduction."

Floyd used this example during the roundtable discussion: If you start Social Security at 62, she said, you'll get 75% of your primary insurance amount and get a 25% reduction. "So let's say you get a job and you receive one Social Security check and then you make enough after that to have all of your benefits withheld," she said. "What happens when you turn 66 is that your benefit will be recalculated, and it will be nearly the full $2,000, so you're getting that 25% actuarial reduction that they took away, you're getting that back, basically. So that's really important for people to understand -- that if you apply early, if you end up having an opportunity to work, take that opportunity and work and not worry about the Social Security."

Never earn delayed credits

Floyd said another point to consider when taking Social Security before full retirement age, or what is also called normal retirement age, is this: "The fact that you applied before full retirement age means that you can never earn delayed credits, so you will, at full retirement age, get your full benefit amount, but no delayed credits. So this is why it's really, really important for people to think hard about applying for Social Security before full retirement age, because it really limits your options."

For his part, Kitces said you should think about paying taxes and reduced benefits this way:

"The taxation of Social Security essentially creates a rule," he said. "If your income is high enough, a portion of your Social Security benefits will be taxed, and in essence, the higher your income is, the greater the percentage is."

"So once we reach an initial threshold, which varies depending on whether you're single or married, you start increasing the taxation of your benefits 50 cents on the dollar. When we get to an upper threshold, we start increasing the taxation of our benefits at 85 cents on the dollar.

And what does that means in practice? "If we earn an extra thousand dollars and we're at the upper threshold, not only do we have another thousand dollars of income we have to report on, but now we have to take $850 of Social Security benefits, and put that on our tax return, and we're going to have to pay taxes on a portion of the Social Security benefits as well," said Kitces.

At some point, "We're taxing 85% of the entire amount of Social Security benefits, which is the cap, and that's as high as we can go," Kitces said. "And from that point forward, there's, in essence, no further impact for higher earnings on causing more of your Social Security benefits to be taxed."

And that, he said, is where some of the confusion exists about earning income and Social Security benefits. "The worst-case scenario is I'm paying taxes on the dollars I earn and I'm paying some taxes on the Social Security benefits that are now also being taxed because my income is higher," he said. "And for most folks at that level, your tax bracket is probably going to be 15% and maybe 25%, and so your worst-case scenario is still I'm going to pay 25% on my income, I'm going to pay another 25% on the Social Security benefits that I just phased in, which was only 85% of them, so I only pay a portion of that 25, and the net point that we get to is still nothing close to taking home less income than you would have had, had you not worked. It simply means you get a little bit of a higher tax burden for a chunk of income as you're causing some Social Security benefits to become taxed."

To be sure, you don't want to pay more than your fair share of taxes if you are working while collecting. So Kitces and Floyd did say that there are tactics to consider. For instance, you consider adjusting your IRA withdrawals. Or you might consider investing in municipal bonds, since the interest income from taxable bond could cause more of your Social Security benefits to be taxed than otherwise.

Still, Kitces and Floyd think you shouldn't let the tax tail wag the earning income dog while collecting Social Security benefits. "We might do other things around the margins to help not make that tax situation impact it even further, but we're still at the point where a dollar you earn puts a bunch of money in your pocket that you didn't have before," said Kitces. "Whether you end up paying tax rates of 15% or 20% or 25% or 30% or 35% or 40%, if we add everything in, and there's estate tax liability and all of it is coming on your income and 85% of your Social Security, you still never get close to the point of 'I just wish I hadn't earned the dollar.'"

See this Social Security website for more information on how benefits are taxed.

Also, read IRS publication 915, Social Security and Equivalent Railroad Retirement Benefits here.

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