Social security has evolved over its 80+ year history from a benefit for retired Americans to a source of supplemental income for more than 63 million people. There are various federal and state tax laws that apply to social security benefits and taxpayers who are new retirees, nearing retirement, or have a spouse who is in either of those situations should learn about the various ways to lower their overall tax bill.
The key is to coordinate income–including wages, pensions, withdrawals from retirement plans, and profits from investments–with your Social Security check. If you strike the right balance, it can make a big difference in the amount of taxes you owe.
Let’s say that you receive the national average of $1,470 per month in Social Security benefits. That’s $17,640 per year. If that was your only source of income–single or married–you would not pay income taxes. However, most people have a more complicated financial situation.
In our example, you would avoid taxes on your Social Security earnings because your total income is below the first threshold: $25,000 for an individual or $32,000 for a married couple. The second threshold taxes up to 50 percent of your Social Security benefits if your income is between $25,000 to $34,000 for an individual or $32,000 to $44,000 for a married couple. The third threshold–and the most likely scenario–taxes up to 85 percent of your benefits if you exceed the first and second tier limits. It’s important to note that no one pays taxes on more than 85 percent of their Social Security check.
Let’s go back to our example of $1,470 per month in Social Security benefits, but this time add income from your spouse’s part-time job, monthly withdrawals from your IRA account, and interest earned from a savings account. That’s probably going to put your income well over the $44,000 threshold, which means nearly $15,000 of your Social Security earnings will be subject to income taxes.
But there are strategies to minimize your Social Security taxes. It can take some serious planning on your part, so it’s best to start thinking about it now if retirement is on the horizon.
Strategies Going Forward
How can you make the most of your Social Security benefits? First and foremost, review your finances with your CPA to get a better understanding of your economic future. There might be sources of income you haven’t considered that can change the calculus. Also, remember the thresholds because they are the basis for most of the tax saving strategies. So, where should you start?
- Manage your other income sources. If the goal is to stay below the thresholds, then you should take a close look at your annual cash flow along with investments and interest-earning savings accounts that may need to be tapped in the future.
If time is on your side, we usually suggest withdrawing funds from your traditional IRA beginning in your 60s–before you sign up for Social Security payments. By moving it to a savings account or making a charitable contribution, then it can’t be counted toward your combined income when you start receiving your Social Security benefits.
Another way to reduce taxable income in retirement is to set up an annuity. An annuity is an investment plan often used by retirees, and it offers some flexibility for withdrawals, helping you stay below the thresholds. For example, let’s say you have $100,000 in certificate of deposits (CDs) earning 3 percent interest. That’s $3,000 added to your income for the year. An annuity reinvests any distributions, so it won’t affect your annual income.
- Delay Social Security payments. If at all possible, we generally encourage you to delay taking your Social Security benefits until you are ready to leave the workforce–otherwise, you will probably exceed the thresholds and maybe even push yourself into a new tax bracket.
You can start receiving benefits as early as age 62, and you can qualify for full benefits at age 66 or 67 depending on birth year. However, some individuals wait until age 70 for a variety of reasons, including tax purposes.
- Use your Roth IRA to your advantage. This one is pretty straight-forward. Any withdrawals from your Roth IRAs after age 59 ½ are tax-free, and they don’t count toward your combined income. So, you can collect Social Security benefits and take distributions from your Roth accounts–all while staying below the income thresholds.
- Set up Social Security withholdings. Realistically, you may end up paying taxes on a portion of your Social Security benefits at some point. If that’s your situation, we encourage you to have federal taxes withheld from monthly earnings. Consult your tax expert for more details.
If you have any questions or would like to start developing your retirement tax strategy, contact the team at Naden/Lean.