Even One Additional Dollar in Income Can Result in a Significant Tax Increase

Taxing your Social Security benefits on your tax return is a fairly common practice. However, you have to understand how the tax is calculated. The tax system can be complicated, and you may be hit with some significant tax increases if you don’t pay attention.

Social Security taxation cliff refers to the fact that even a slight increase in income can result in a substantial tax increase. Social Security benefits may be taxed at a rate of 85%, 50%, or even zero, depending on your other income.

Why is There a cliff?

According to Marketwatch, a cliff implies a one-time change in altitude, so it’s a bit misnomer. In fact, the Social Security thresholds change your tax bracket, but that change doesn’t occur once. As your income rises above the threshold(s), a greater portion of your Social Security benefit becomes taxable.

As an example, let me give you the following:

Meg and Johnny receive $16,000 in Social Security benefits annually. In addition, there is a total of $40,000 they receive from their pensions and IRAs. In order to keep things simple, they do not include nontaxable income in their calculations. The following illustrates how the Social Security benefit is taxed in their case.

Considering Meg and Johnny’s PI just goes over the second threshold a bit, a portion of their Social Security benefit is included at the 50% rate (line 7) and a portion at the 85% rate. A total of 58.75% of their Social Security benefits are taxable.

The cliff concept now comes into play. When you are approaching a cliff, you are fine until you take the next step. The same applies to Social Security taxes. In this case, it will be as follows:

As a result of this addition to income, their Social Security taxability rate now stands at 64%, up from 58.75% before.

Their adjusted gross income increases by $1,850 when they increase their overall income for the year by the $1,000 additional withdrawal. Assuming no Social Security taxation issues exist, in this situation the couple’s tax liability would be $120 greater if their income increased by $1,000 (using 2022 tax tables). Meg and Johnny’s actual increase is $222, which means they paid 22.2% in tax on that $1,000 withdrawal.

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By reducing their PI by $1,000, Meg and Johnny would have a lower tax-based Social Security benefit to $8,550, or only 53.34% included in their Social Security check.

Are There Any Steps You Can Take to Prevent This?

The first thing you need to realize is that this situation only occurs where the PI falls between $32,000 and $50,000 to $60,000 (for married filers filing jointly). When Meg and Johnny’s PI is above $53,000, their Social Security benefits will be fully taxable at 85%. Between $25,000 and approximately $45,000 is the range for singles and heads of household. You have no taxable Social Security income when your PI is below these thresholds. If your Social Security benefit exceeds the upper range, then it will be taxed at 85%.

If you’re somewhere in the middle, you should take note of how your benefits are taxed. If you can manage your income somewhat, then you can bring in some income in one year (and pay the taxes), thereby making the following year (or the previous year) a leaner year.

You might consider doing a Roth conversion in order to lower your IRA Required Minimum Distribution (RMD) if it is the reason you are over the threshold(s). By reducing your included Social Security benefits, a systematic Roth conversion strategy could be very beneficial prior to receive Social Security benefits. If you convert to a Roth, keep in mind that you can also incur additional income-related expenses, such as Medicare premiums.