My recent column on how income from a job can temporarily reduce or even eliminate Social Security benefits claimed before full retirement age prompted some interesting questions from readers.
Those questions allow me to clarify how earnings from a job or net self-employment income can reduce current Social Security benefits while boosting future benefits. They also give me an opportunity to explain how an individual's income is the triggering factor in applying the earnings test, but household income is used when calculating the taxability of Social Security benefits or the application of a Medicare high-income premium surcharge.
As a quick recap, the Social Security earnings cap temporarily reduces benefits if an individual claims benefits before full retirement age while continuing to work. In 2018, someone who is under full retirement age for the entire year would lose $1 in benefits for every $2 earned over $17,040. The test applies to individuals' earned income whether they're single, married, divorced or widowed.
If someone turns 66 this year, there is a more generous earnings cap. That person could earn as much as $45,360 in the months before his or her 66th birthday without sacrificing any benefits and would forfeit $1 in benefits for every $3 earned over the limit. The earnings cap disappears at full retirement age, meaning someone age 66 or older could earn any amount of money from a job or self-employment without forfeiting any Social Security benefits.
Any benefits that were lost to the earnings cap are restored at full retirement age in the form of higher monthly premiums. Plus, those earnings could boost future benefits even further if recent annual earnings replace a previous year of lower earnings used in the benefit calculation, which is based on the top 35 years of annual indexed earnings.
In my column, I noted that some earnings, known as "special payments," don't count against the earnings test. This includes income earned prior to retirement but paid out after retirement, such as ongoing insurance policy sales commissions, or lump sum payouts of unused vacation time or sick leave.
That prompted one reader to ask if those trailing commissions, which are excluded from the earnings test, are also excluded from the calculation used to determine what portion of Social Security benefits is subject to federal taxes.
No. Such special payments are included in the "combined income" formula that determines how much of your Social Security benefits are subject to federal taxes. Combined income is defined as adjusted gross income, plus one-half of Social Security benefits, which are not included in the AGI calculation, plus any tax-exempt interest.
If an individual's combined income exceeds $25,000 or if a married couple's joint combined income exceeds $32,000, up to 85% of household Social Security benefits can be taxed.
Combining Social Security benefits with ordinary income, such as IRA withdrawals or capital gains, can create a snowball effect in which the resulting tax on one additional dollar of income can be far greater than what was expected, warns Joe Elsasser, founder of Covisum, a training and software company that helps advisers create retirement income plans through smart Social Security claiming strategies and tax-efficient withdrawals.
William Meyer, founder of Social Security Solutions, a competing software and training company, calls this phenomenon the "tax torpedo," a reference to the sharp spike and subsequent decline in retirees' marginal tax rate on Social Security benefits as their income increases.
There is a separate income calculation that determines how much Medicare beneficiaries pay each year. Although most people enrolled in Medicare in 2018 pay $134 per month for Part B, which covers outpatient services and doctors fee, high-income enrollees pay more — in some cases, much more.
If your clients' modified adjusted gross income, or MAGI, tops $85,000 if they are single or $170,000 if they are married, they are subject to high-income surcharges that can boost their monthly Medicare premiums to as much as $428.60 per person in 2018. Surcharges also apply to Medicare Part D prescription drug plan premiums.
MAGI includes AGI plus tax-exempt interest. Unlike the combined income formula that determines the taxability of Social Security benefits, MAGI does not add back half of Social Security benefits.
The Medicare surcharges, officially known as income-related monthly adjustment amounts, or IRMAA, are based on the latest available tax returns, so 2018 Medicare surcharges reflect income reported on 2016 tax returns.
As more and more clients plan to keep working beyond the age when they qualify for Social Security and Medicare benefits, it is important that financial advisers understand which type of income — individual or household — can trigger complex rules regarding Social Security benefits, income taxes and Medicare premiums.