Social Security benefits were once tax-free. That changed in 1983, when Congress decided to tax a portion of benefits for the highest-income recipients. Back then, fewer than 10% of beneficiaries were affected. Lawmakers failed to update the law to account for inflation, however, so today most Social Security beneficiaries have to pay federal income tax
Social Security benefits were once tax-free. That changed in 1983, when Congress decided to tax a portion of benefits for the highest-income recipients.
Back then, fewer than 10% of beneficiaries were affected. Lawmakers failed to update the law to account for inflation, however, so today most Social Security beneficiaries have to pay federal income tax on at least some of their benefits, says Ted Sarenski, author of American Institute of CPA’s “Guide to Social Security Planning.”
There are a few ways to reduce that tax bite, however, especially if you can plan ahead.
HOW SOCIAL SECURITY TAXES WORK
Social Security taxes are based on your annual “combined income.” Combined income comprises:
●Your adjusted gross income, which includes your earnings, investment income, retirement plan withdrawals and other taxable income.
●Any nontaxable interest you receive, such as interest on municipal bonds.
●One half of your Social Security benefits.
For couples filing a joint return, a combined income between $32,000 and $44,000 means up to 50% of benefits may be taxable. For higher combined incomes, up to 85% of benefits may be taxable. Single filers may pay tax on up to 50% of benefits when combined income is between $25,000 and $34,000, and up to 85% of benefits beyond that.
People who live solely on Social Security don’t have to pay income taxes on their benefits, Sarenski notes. But even a relatively small amount of other income can cause benefits to become taxable.
DEFUSE THE TAX TORPEDO
The unique way Social Security benefits are taxed leads to something known as the “tax torpedo” – a sharp rise in marginal tax rates followed by a decline, says William Reichenstein, professor emeritus at Baylor University and co-author of “Social Security Strategies: How to Optimize Retirement Benefits.” Marginal tax rates are what you pay on each additional dollar of taxable income you receive.
Many middle-income households can face marginal tax rates that are 50% to 85% higher than their regular tax bracket because of this tax torpedo, Reichenstein says.
“You take another dollar out of your tax deferred account and it causes another 85 cents of Social Security to be taxed, so your taxable income goes up by $1.85,” he says.
Moderate-income households may be able to defuse the effects by delaying the start of Social Security benefits as long as possible, Reichenstein says. Someone who waits until age 70 to start benefits, withdrawing money from retirement funds in the meantime, not only gets a larger Social Security check but could save hundreds or even thousands of dollars a year in taxes, Reichenstein says. If you’re in the 10% to 22% federal tax brackets, consider talking to a tax pro or financial planner about how to mitigate the potential tax burden.
CONTRIBUTE TO A ROTH
Having at least some money in a Roth IRA or Roth 401(k) can help reduce taxes on Social Security benefits. Withdrawals from these accounts are tax-free in retirement and aren’t included in your combined income, Sarenski says.
You can’t contribute to a retirement account if you don’t have earned income, so people should diversify their retirement accounts long before they stop working, he says. Putting all your money in a pretax option could mean facing a whopping tax bill later.
“People should be trying to balance what they have in pre-tax income and after-tax income so they can balance their taxation in the future when they retire,” Sarenski says.
GET CHARITABLE WITH YOUR IRA
Once you’re 70 1/2, you can make qualified charitable distributions, which are donations from your IRA to a charity. The withdrawal isn’t taxable and won’t count in your combined income as long as the money is transferred directly from the IRA custodian to the charity. You can transfer up to $100,000 this way.
If you’ve reached the age at which required minimum distributions from retirement accounts must begin – currently, that age is 73 – qualified charitable distributions can count as your RMD, Sarenski says.
CONSIDER OTHER WAYS TO REDUCE DISTRIBUTIONS
If you’ve been a good saver, RMDs can push you into a higher tax bracket as well as trigger higher Social Security taxes, Sarenski says.
Tapping your retirement funds before you’re forced to do so could make sense, as could a Roth conversion, Sarenski says. With a conversion, money is transferred to a Roth IRA from a pretax retirement account such as an IRA or 401(k). Conversions typically incur taxes but withdrawals in retirement are tax-free.
Again, consider talking to a tax pro or financial planner first. Taking too much from retirement accounts can trigger unnecessary taxes, increase your Medicare or Affordable Care Act premiums and have other financial repercussions, such as running out of money prematurely. Avoiding those pitfalls takes careful planning, Sarenski says.
“The idea to me is to smooth out your tax rates,” Sarenski says. “You don’t want years where you’re paying at 40% and years where you’re paying zero.”
This column was provided to The Associated Press by the personal finance website NerdWallet. Liz Weston is a columnist at NerdWallet, a certified financial planner and author of “Your Credit Score.” Email: email@example.com. Twitter: @lizweston.
NerdWallet: Social Security: How It’s Taxed, How to Save https://bit.ly/social-security-taxed
Liz Weston Of Nerdwallet, The Associated Press