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Social security and tax considerations

Social Security is a vital lifeline for millions of senior citizens. It is also a potential political football as a federal government hard-pressed for cash considers its options for tax increases.

The Social Security system is funded by taxes from both employers and employees. Employees pay 6.2 percent of their earned wages up to $110,000. (They also pay 1.45 percent for Medicare.) Employers match the contribution by employees.

For self-employed people, the funding mechanism works a bit differently. Self-employed people pay a total of 15.3 percent of income through the self-employment tax.

In 2011 and 2012, the government reduced the employee share of the Social Security tax from 6.2 percent to 4.2 percent. The employer contribution stayed the same, however, and self-employed people were not eligible.

Now, of course, with the so-called "fiscal cliff" looming at the end of the year, the payroll tax reduction is scheduled to expire. It remains to be seen whether Congress and the Obama administration will take action to delay or mitigate the expiration.

But as important as that is, it isn't the only issue regarding Social Security. It's also important to consider the taxability of Social Security benefits for those who are collecting them. These benefits could be taxable for individuals who make more than $25,000 a year, or for married couples filing jointly with incomes over $32,000 per year.

The amount of the tax on benefits requires careful calculation. The equation involves adding up other taxable income, as well as tax-exempt interest.

The fairness of taxing Social Security benefits is definitely debatable. After all, if Social Security is genuinely supposed to function as a retirement program, either the original contributions over the distributions at retirement should be sheltered from tax. But they are not.

Source: "Why do We Tax Social Security Benefits?" Fox Business, Bonnie Lee, 11-8-12

Our firm handles situations similar to those discussed in this post. To learn more about our practice, please visit our individual income taxes page.

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