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I get $3,300 a month from Social Security. How can I reduce my taxes?

A man does a rough calculation to determine how much he will pay in taxes on his Social Security benefits.

According to the Social Security Administration, about 40% of households pay taxes on their Social Security benefits. If you owe taxes on your benefits, managing them effectively can save you a lot of money.

If you need help planning for Social Security or taxes after retirement, consider working with a financial advisor.

However, there aren’t many ways to do that. Social Security taxes are based on a fairly simple income formula. The only real way to reduce how much of your benefits are taxable is to reduce your taxable income or qualify for a lower marginal tax rate.

For example, suppose you expect to earn $3,300 per month from Social Security. Here’s how your taxes work and how you might be able to reduce taxes on those payments.

How are social security benefits taxed?

Up to 85% of an individual's Social Security benefits may be subject to taxes, depending on their combined income.Up to 85% of an individual's Social Security benefits may be subject to taxes, depending on their combined income.

Up to 85% of an individual’s Social Security benefits may be subject to taxes, depending on their combined income.

Depending on your income, a percentage of your Social Security benefits may be included in your taxable income. This usually applies if you have additional income beyond your Social Security benefits, although high earners in particular may face taxes based on their benefits alone.

Benefit taxes are calculated using two separate figures: combined income and taxable income. Your combined income is used to determine the amount of Social Security benefits that will be taxed. Your taxable income is a separate figure used to determine your actual taxes.

Combined income

First you calculate your joint income:

So in our example, you have $39,600 per year in Social Security income. If there is no other income, you will have a joint starting income of $19,800.

If your combined income is less than $25,000 as an individual or $32,000 as a married couple, you don’t pay taxes on your Social Security benefits. If your combined income is between $25,000 and $34,000 as an individual or between $32,000 and $44,000 as a married couple, you’ll pay taxes on up to 50% of your benefits. This can be a sliding scale. Your exact rate will be determined by IRS Publication 915.

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If your combined income is more than $34,000 as an individual or more than $44,000 as a married couple, you will pay taxes on up to 85% of your Social Security benefits. Again, this can be a sliding scale.

Taxable income

Once you know your tax rate, you can calculate your taxable income.

To do this, multiply your tax rate (0%, 50%, or 85%) times your total Social Security Benefits. You then add the resulting amount to the rest of your taxable income. Your tax will then be calculated on this total.

The result of this system is that some of your benefits are taxed and some are not. For example, suppose you fall into the 85% bracket. In this case, you add 85% of your benefits to your taxable income and pay no tax on 15% of your benefits.

Like most retirement income, the benefits are not subject to FICA taxes, so you only pay income taxes on this money.

Examples of social security benefits

Let’s look at our hypothetical scenario using three different examples. (You can also run your own numbers through the IRS tax calculator.) We’ll assume you’re single.

Example 1: Social Security as your only source of income

Here you only have Social Security benefits ($39,600) and no other sources of retirement income. Your taxes are based on the following information:

  • Combined income: $0 + $0 + (0.5 * $39,600) = $19,800

  • Social Security Tax Level: 0%

Normally, with an income of $19,800, you would pay $595 in federal taxes (without special credits or deductions). However, your combined income falls below the $25,000 threshold, so none of your benefits are taxable. As a result, you would have no taxable income and pay no federal income tax.

Example 2: $12,000 in 401(k) withdrawals

Here you have Social Security benefits plus an additional $12,000 per year from your 401(k). Your taxes are based on the following:

  • Combined income: $12,000 + $0 + (0.5 * $39,600) = $31,800

  • Social Security Tax Level: 50%

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Since your combined income as an individual is between $25,000 and $34,000, 50% of your Social Security benefits are added to your taxable income. As a result, your taxable income would be the same as your combined income, and you would owe approximately $1,934 in federal income tax.

Example 3: $50,000 in 401(k) withdrawals

In our third scenario, you will have Social Security benefits plus an additional $50,000 per year from your 401(k). Your taxes are calculated based on the following:

  • Combined income: $50,000 + $0 + (0.5 * $39,600) = $69,800

  • Social Security Tax Level: 85%

Because your combined income as an individual is greater than $34,000, you pay taxes on 85% of your Social Security benefits. As a result, your taxable income would be $83,575 ($50,000 + $33,660) and you would owe approximately $10,666 in federal income tax.

Please note that these are estimates. If you need help calculating your own tax liability, consider working with a financial advisor with tax expertise.

Reducing your Social Security benefits

A couple looks at their finances to determine how they can reduce the taxes they pay on their Social Security benefits. A couple looks at their finances to determine how they can reduce the taxes they pay on their Social Security benefits.

A couple looks at their finances to determine how they can reduce the taxes they pay on their Social Security benefits.

So, how can you reduce taxes on your Social Security benefits?

Overall, the only way to reduce the taxes you pay on Social Security benefits is to reduce your taxable income, your marginal tax rate, or both.

It’s important to note that you can help manage the impact of these taxes by filing for federal withholding. If you do this, the SSA will withhold your likely taxes from each benefit check, helping you avoid a nasty income tax bill when you file your tax return for the year.

Additionally, here are some strategies to reduce your tax liability:

Roth Conversions

This is perhaps the simplest option. Income you generate from a Roth IRA does not count as taxable income nor is it subject to required minimum distributions (RMDs). Because Roth withdrawals are not part of your adjusted gross income, they are also not calculated in your combined income for tax purposes. As a result, if you generate most or all of your income from Roth withdrawals, your Social Security benefits may not be subject to any significant tax (depending on your benefit amount).

That said, remember that Roth conversions come with hefty upfront tax costs. For households nearing or in retirement, converting a significant amount of money from a pre-tax portfolio may leave you paying more in taxes on the conversion than what you would save on your Social Security taxes.

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Capital Gains Conversions

This is equivalent to Roth conversions, but generally less beneficial.

Here you would move your money from a pre-tax retirement account to a taxable brokerage account. From there, your withdrawals may be subject to a combination of capital gains and income taxes, depending on the nature and duration of your investments. However, returns subject to capital gains tax do not count towards your combined income, again giving you an advantage when calculating the share of gains subject to tax.

However, you still pay taxes up front on the money you take out of your pre-tax portfolio. For this reason, households may do better with a Roth conversion (which eliminates taxes entirely) than a capital gains conversion (which restructures taxes).

Structure your recordings

Finally, you can structure your withdrawals around tax levels.

While even a small amount of additional income can push you into the 85% bracket, manipulating your income around these tax levels can be very helpful.

The key here is to remember two things. First, savings do not count as income for tax purposes. Second, the tax rates apply to your entire benefit check. So the idea is that you can withdraw extra money above a certain level in one year, put it aside in your savings and then withdraw less for a number of years.

The goal is to keep your joint income within the 0% or 50% bracket as often as possible. However, the cost is that you will miss out on investment returns for the money you have in savings accounts.

Let’s say you generally want to take $15,000 out of your 401(k). By itself, this would give you a combined income of $34,800 ($15,000 + $19,800), so you would pay taxes on 85% of your benefits. Instead, you can withdraw $20,000 in a year and still pay taxes on 85% of your distributions. You can then withdraw €14,000 from your portfolio and €1,000 from your savings over the next four years. That would give you a combined income of $33,800, so over those four years you would only pay taxes on 50% of your benefits.

This type of structured withdrawal is difficult to manage, especially in the long term. It is best accomplished with the help of a financial advisor, someone who can help you prepare for this type of tax planning years in advance.

In short

Social Security benefits are taxed based on the total income you have. The only real way to reduce those taxes is to lower your tax rate or reduce your income, which is often best done with a Roth IRA or structured withdrawals.

Tips for Social Security Benefits

Photo credit: ©iStock.com/Eleganza, ©iStock.com/South_agency, ©iStock.com/MariuszBlach

The post I’m going to get $3,300 a month from Social Security. How can I reduce my taxes? first appeared on SmartReads by SmartAsset.

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