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Social Security plays a critical role in the retirement plans of millions of Americans, but how these benefits are taxed is sometimes overlooked. If you receive $2,700 per month in Social Security benefits, your check will be well above the average retirement benefit of about $1,800 per month, and this may mean you owe taxes on this money. However, there are ways to potentially reduce your tax liability. Consider working with a financial advisor to create a comprehensive financial plan for retirement that takes into account your Social Security benefits and tax situation.
Social Security taxes are calculated on a “combined income” basis. As your combined income increases, you may owe taxes on a larger percentage of your benefits. This is how the combined income is calculated:
For example, suppose you withdraw $50,000 from your 401(k) and receive $40,000 in annual Social Security benefits. Your combined income would be $70,000 ($50,000 + $40,000/2).
From there, the IRS uses the following income levels to tax the benefits of people who file their taxes as individuals:
Combined income less than 25,000: Distributions are not taxable
Combined income between $25,000 and $34,000: Up to 50% of benefits are taxable
Combined income above $34,000: Up to 85% of benefits are taxable
If you file a return jointly with your spouse, the following income levels determine the taxability of your social security:
Combined income less than $32,000: Benefits are not taxable
Combined income between $32,000 and $44,000: Up to 50% of benefits are taxable
Combined income above $44,000: Up to 85% of benefits are taxable
Please note: these are not the tax rates. Rather, this means that up to 50% or up to 85% of your Social Security benefits are subject to your regular income tax rates. But if you need help assessing your tax liability, consider speaking to a financial advisor with tax expertise.
It’s important to remember that your Social Security benefits may be taxable depending on your “combined income.”
As we mentioned above, the more combined income you have, the more of your benefits could potentially be taxed. If you collect $2,700 per month, that’s $32,400 per year in Social Security benefits, giving you a combined starting income of $16,200 ($32,400/2). If Social Security were your only source of income, you would not owe taxes on your benefits.
From there, taxes apply depending on your other sources of income. For example, let’s say you withdraw $50,000 from your 401(k). That would make your combined income $66,200 (50,000+16,200), meaning up to 85% of your benefits – $27,540 – would be taxable.
So here are a few strategies to potentially lower your taxes.
The first option is to manage withdrawals from your retirement account. This depends entirely on your retirement budget and lifestyle, but the less you withdraw, the more you can stay under the IRS tax caps.
In this case, you start with a combined income of $16,200. If you withdraw less than $8,800 ($15,800 if you’re married and filing jointly) from your retirement accounts, your combined income won’t trigger a tax on your benefits. If you take less than $17,800 ($27,800 if married) in additional income, you will only pay taxes on up to half of your benefits. The problem, of course, is that this could mean living on an unrealistically tight budget. Keep in mind that a financial advisor can help you create a budget and income plan for your retirement.
Perhaps a more realistic way to manage your retirement withdrawals is to rely on Roth accounts. The money you take from a Roth IRA or a Roth 401(k) does not contribute to your taxable income for the year, so these withdrawals will not affect your combined income. This leads to two possible strategies.
First, you can maximize Roth withdrawals. Taking all of your retirement income out of a Roth account leaves your combined income at $16,200.
However, this approach can drain your Roth portfolios too quickly. Instead, you can structure your Roth withdrawals around Social Security levels. By doing this, you limit your withdrawals from tax-deferred accounts so that your combined income remains below the 50% or 85% threshold. You would then use Roth accounts for all withdrawals that would otherwise trigger these higher thresholds.
For example, suppose you want to withdraw €50,000 per year in additional pension income. You can withdraw $17,799 from a traditional IRA and $32,201 from a Roth IRA. This would give you a combined income of $33,999, making only 50% of your benefits taxable.
And if you need help with Roth conversions or managing your Roth accounts, consider working with a financial advisor.
You can also defer your Social Security benefits and live entirely off portfolio withdrawals during your 60s. Then, you can start collecting Social Security benefits at age 70, when your benefits are maxed out.
You do not pay tax on the benefits you have deferred. At age 70, you would receive more benefits and reduce the amount of money you need to withdraw from your portfolio. This would have the effect of reducing your annual combined income by thousands of dollars. However, it would require having enough money in your retirement accounts and additional planning to ensure that you don’t run out of money later in life.
A retired couple discusses their finances.
Taxes on Social Security benefits are based on your household’s taxable income. How much of your benefit is subject to taxes is largely based on three levels: 0%, 50% or 85%. However, you may be able to lower your Social Security taxes through structured portfolio withdrawals, Roth conversions, or simply withdrawing less.
Planning for Social Security is critical. If you need help estimating the amount of your benefits so you can decide when to claim them, SmartAsset’s Social Security Calculator is a good tool to use.
A financial advisor can help you plan for Social Security benefits and make other financial decisions that may affect your tax liability in retirement. Finding a financial advisor does not have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors serving your area, and you can have a free introductory meeting with your advisors to decide which one you think is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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