Are you paying too much tax on your social security? This is how you reduce this tax

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Millions of Americans rely on Social Security benefits for all or part of their retirement income. Up to 85% of Social Security benefits are subject to federal income tax, depending on your total household income. However, Fidelity recently introduced options for taxpayers to reduce their tax payments on Social Security benefits. Delaying Social Security claims and reducing withdrawals from traditional IRAs are two popular ways that Social Security recipients can reduce their tax bills. A few others may work, depending on your specific situation.

A financial advisor can help you minimize taxes on your Social Security benefits. Talk to an advisor today.

Basic Principles of Social Security Tax

You must pay taxes on Social Security benefits if your combined income exceeds certain thresholds. Social Security uses a number called “joint income” to determine whether your income exceeds the thresholds where you owe taxes on benefits. The formula to determine your joint income is:

Combined income = adjusted gross income (AGI) + non-taxable interest + 1/2 of social security benefits

Singles with a combined income of more than $25,000, and married couples filing joint tax returns of more than $32,000, may pay taxes on up to 85% of these benefits.

Strategies for Managing Social Security Taxes

Although Social Security benefits are subject to tax, benefits are taxed at a lower rate than other sources of income. For example, up to 85% of Social Security benefits can be taxed, versus 100% of IRA withdrawals. This makes Social Security a valuable source of income for retirees.

If you don’t do anything to manage how your Social Security benefits are taxed, you could end up with less net income in retirement that you can use to support your lifestyle. Fidelity explains two common strategies for doing just that:

1. Roth conversion: Converting savings into a Roth IRA allows you to take tax-free withdrawals from the Roth account without increasing your combined income. This Roth conversion strategy allows you to claim Social Security benefits without paying more taxes on them.

2. Postponement of social security: Although you can start claiming Social Security benefits as early as age 62, waiting to claim increases the size of your benefit checks. This means that a smaller portion of what you need to pay for living expenses will have to come from taxable IRA income.

How Managing Social Security Taxes Works

As a hypothetical example of the dollar impact of using the second strategy, assume a couple plans to retire at age 65. They pay for their retirement with a combination of Social Security and IRA withdrawals totaling $70,000 after taxes. They claim the standard deduction of $27,700 and use the 2023 income tax brackets.

The story continues

If they claim their Social Security benefits at age 65, Social Security will pay a total of $24,000 annually. Eighty-five percent of that is taxable. They must withdraw $50,777 from their retirement account and pay $4,777 in income taxes, for a total of $70,000 after taxes are paid.

Now consider what happens if they wait until age 70, when their Social Security benefit increases to $34,000 a year. Now they withdraw only $38,820 from their IRA, and because this reduces their combined income, only 47% of their Social Security benefit is taxable. The tax bill drops to $2,820 for a savings of $1,957.

To further reduce taxes, taxpayers can contribute to Roth IRAs and Roth 401(k)s before withdrawing Social Security. These accounts allow tax-free withdrawals. Taxpayers can also withdraw more from traditional IRAs before claiming distributions. This spreads the tax impact over more years.

Consider hiring a financial advisor if you need help arranging your retirement income and taxes.

Tax reduction limits for social security benefits

You may be able to avoid paying federal income taxes on all or part of your Social Security benefits using these popular strategies, but they won’t necessarily allow all people in all situations to avoid all taxes. For example, where you live is a factor. Some states offer deductions or exemptions on Social Security income, but others tax benefits completely.

One major potential downside that may apply regardless of where you live is that converting too much pre-tax savings to a Roth IRA now could push you into a higher tax bracket. This can negate the long-term tax savings on Social Security benefits.

Furthermore, examples such as the above only apply if the retired couple has sufficient financial resources to postpone taking an AOW benefit until the age of 70.

Additional strategies to reduce taxes

In addition to Roth IRA conversions and deferring Social Security payments, other techniques can reduce your tax burden:

• Withdraw more from taxable investment accounts like traditional IRA and 401(k) plans before claiming Social Security. This spreads the tax impact over more years.

• If you have a traditional 401(k), take distributions before you take Social Security. You will pay taxes on the 401(k) money anyway.

• Contribute to a Health Savings Account (HSA). Benefits from the HSA do not count as income for Social Security tax purposes.

• If you are married, let the partner who earns the most claim Social Security benefits first, so that the taxable family income is reduced.

• Move from high-tax states to low-tax or no-tax states. Some states don’t tax Social Security benefits at all.

• Consider speaking to a financial advisor who can give you professional and reliable advice.

Conclusion

Social Security benefits are taxed, but they have some special tax breaks that allow retirees to lower their overall tax burden using a few popular techniques. Strategic moves like Roth IRA conversions and deferring Social Security can significantly reduce your tax burden during retirement. These techniques may require you to pay taxes up front for your retirement. And states tax Social Security in a variety of ways, some of which may not be reduced by these steps.

Tips for retirement planning

• Before making any major financial decisions, consider working with a financial advisor who can assess your specific situation. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can schedule a free introductory meeting with your advisors to determine which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

• Calculate how much you will receive from Social Security in the future with SmartAsset’s Social Security Calculator.

• Keep an emergency fund on hand in case you run into unexpected expenses. An emergency fund should be liquid—in an account that isn’t subject to big swings like the stock market. The tradeoff is that the value of liquid assets can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.

• Are you a financial advisor looking to grow your business? SmartAsset AMP helps advisors connect with leads and provides marketing automation solutions so you can spend more time on conversions. Learn more about SmartAsset AMP.

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The post You May Be Paying Too Much Tax on Your Social Security Benefits. Here’s How to Reduce Them appeared first on SmartReads by SmartAsset.