Advanced Diploma of Financial Planning (ADFP) Practice Test

What may be subject to federal income tax for individuals with substantial income in addition to Social Security benefits?

1. 50% of their annual benefits

2. 75% of their annual benefits

3. Up to 85% of their annual benefits

4. No portion of their benefits

The correct answer is: Up to 85% of their annual benefits

Social Security benefits may be subject to federal income tax depending on an individual's total income level, including other sources of income. For individuals with substantial income, up to 85% of their Social Security benefits can be included in their taxable income. The taxation of Social Security benefits is determined by the individual's "combined income," which is calculated as the sum of adjusted gross income, non-taxable interest, and one half of the total Social Security benefits received. When this combined income exceeds specified thresholds, a portion of the Social Security benefits becomes taxable. For many taxpayers, this means that higher income levels result in a greater portion of their Social Security benefits being subject to federal tax, hence the correct response indicates that up to 85% of the benefits can be taxed. Understanding these thresholds and the mechanics of how the incomes interrelate is crucial for tax planning, particularly for those in a higher income bracket.