Tax bill on 2023 Social Security benefits could catch retirees off guard
Last year's 8.7% COLA may push many recipients over the income threshold for the first time.
Many retirees’ budgets may take a hit for the first time this tax season — a federal income tax bill on a portion of their Social Security benefits.
Social Security recipients received a high cost-of-living adjustment (COLA) of 8.7% in 2023 — an average of $140 more per month — the largest hike in more than 40 years. That boost might just push them over the income threshold that makes their benefits taxable.
Read more: How to find out your 2024 Social Security COLA increase
The bar is lower than you might think. A married couple with as little as $32,000 in combined income could get a tax bill.
"We expect more beneficiaries to become liable for federal income taxes on their Social Security benefits for the first time in the upcoming 2024 tax season," Mary Johnson, a Social Security and Medicare policy analyst for The Senior Citizens League, told Yahoo Finance.
That could "catch them off-guard," she added.
An unexpected tax bill would be another setback for seniors who grapple with making ends meet. Even though inflation is significantly below its peak of 9.1% in June 2022, the highest level in four decades, high costs continue to chip away at retirees’ budgets.
Full coverage: Taxes 2024 — Everything you need to file your taxes on time
In December, consumer prices increased more than expected. The Consumer Price Index (CPI) showed prices ticked up slightly at 0.3% over last month and 3.4% over the prior year. Among items on the rise — rents, electricity, gasoline, and car insurance.
In a recent Senior Citizens League survey, more than two-thirds of older adults said their monthly budget for essential items such as housing, food, and prescription drugs is 10% higher than one year ago.
Pile on higher costs for Medicare this year. The standard monthly Part B rate rose from $164.90 to $174.70. The annual deductible for all Medicare Part B beneficiaries is $240 in 2024, an increase of $14 from 2023.
"That's a big shocker for our clients," Ryan Haiss, a certified financial planner at Flynn Zito Capital Management in Garden City, N.Y., told Yahoo Finance. "Many people see that Social Security benefits will go up, but they don’t see that their Medicare premiums have gone up as well."
"We do a lot of planning for retirees, and part of that is the explanation to our clients that Social Security will be taxable for many," he said.
The rules for Social Security benefits and taxes
Most states do not tax Social Security benefits, but about 40% of people who get Social Security must pay federal income taxes on their benefits, according to the Social Security Administration. If you file a federal tax return as an individual and your combined income from all sources, including your Social Security benefit, is between $25,000 and $34,000, you may have to pay income tax on up to 50% of your benefits. If your income exceeds $34,000, up to 85% of your benefits may be taxable.
For joint filers, if you and your spouse have a combined income between $32,000 and $44,000, you may have to pay income tax on up to 50% of your benefits; if it's more than $44,000, up to 85% of your benefits may be taxable.
"A lot of our clients will exceed the $44,000 of combined income for Married Filing Jointly, and it is just something that is understood, and we need to consider when planning for retirement," Haiss added.
Why the modest income cut-off for tax eligibility
Shockingly, unlike income tax brackets and the standard deduction, these income thresholds have never been adjusted for inflation since the law that taxed Social Security benefits first became effective in 1984.
"Because the cutoff doesn't grow with inflation, an increasing number of households, over time, will face taxes on their benefits," Anqi Chen, assistant director of savings research for the Center for Retirement Research at Boston College, told Yahoo Finance.
"Keep in mind that even at higher income levels, only a portion of your benefit will be taxed," she added, noting that the effective rate — the amount you actually pay — is much lower for Social Security benefits than for typical taxes on other earned income.
Nonetheless, per Johnson: "If those thresholds were adjusted to today’s dollars, the $25,000 threshold would be about $75,330 and the $32,000 threshold would be about $96,424."
It’s not just the extra cabbage in the monthly Social Security check that triggers the tax bill; it’s when you add it with your other income. Your total income consists of your adjusted gross income, untaxed interest, and half of your annual Social Security payments.
If you are receiving Social Security, once you turn 73 and must begin taking required minimum distributions from IRAs and other tax-deferred accounts, those combined income streams can easily bump you above those taxable limits. The amount you must pull out for your RMD is calculated by dividing your tax-deferred retirement account balance as of Dec. 31 of the preceding year by a life expectancy factor that corresponds with your age in the IRS Uniform Lifetime Table. As your life expectancy declines, the percentage of your assets that must be withdrawn ramps up.
The 2022 tax year could be a precursor to what retirees may experience this year when their tax bill comes due. A survey by the Senior Citizens League asked 4,375 older taxpayers if they had to pay federal income tax on a portion of their Social Security benefits for the first time that year when the COLA was 5.9%.
Nearly a quarter said yes.
"The number of yeses is even more likely to rise this year given the 8.7% COLA in 2023," Johnson said.
Planning ahead
You can run your numbers in order to figure out if your Social Security benefits might be taxable this year on the IRS’s calculator.
Looking ahead, Social Security benefits rose 3.2% for 2024. The increase adds more than $50 to the average monthly benefit, hiking it from $1,848 to $1,907 starting this month, according to the Social Security Administration. While that is a much smaller increase than the COLA increases for the two previous years, it still falls above the average increase of 2.6% during the last 10 years.
One other thing to keep an eye on when you’re doing your tax planning is income from your savings and investment accounts, which took a leap up. For instance, if you shifted savings into higher yielding CDs, that can push up your taxable income.
"Many retirees have taken advantage of today’s higher interest rate environment through CD’s and high-yield savings vehicles, which is great," Haiss said. "But [it’s] important to note any interest earned on those investments is taxed at ordinary income rates."
Kerry Hannon is a Senior Columnist at Yahoo Finance. She is a workplace futurist, a career and retirement strategist, and the author of 14 books, including "In Control at 50+: How to Succeed in The New World of Work" and "Never Too Old To Get Rich." Follow her on X @kerryhannon.
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