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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 presented options for taxpayers to reduce the amount they pay in taxes on Social Security benefits. Delaying Social Security claims and reducing withdrawals from traditional IRAs are two popular ways Social Security recipients can reduce their tax bills. Some others may also work depending on your specific situation.
A financial advisor can help you minimize taxes on your Social Security benefits. Talk to an advisor today.
You must pay taxes on Social Security benefits if your combined income exceeds certain thresholds. Social Security uses a figure called combined income to determine whether your income is above 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
Single filers with combined income over $25,000, and married joint filers over $32,000, may pay taxes on up to 85% of these benefits.
Although Social Security benefits are subject to tax, benefits are taxed at a lower rate than other sources of income. For example, a maximum of 85% of Social Security benefits may be taxed, compared to 100% of IRA withdrawals. This makes Social Security a valuable source of income for retirees.
If you don’t do anything to manage the way your Social Security benefits are taxed, you may end up with lower after-tax income in retirement that you can use to support your lifestyle. Fidelity distinguishes two commonly used strategies to do this:
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Roth conversion: If you convert savings into a Roth IRA, you can make 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.
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Postponing Social Security: Although you can start claiming Social Security benefits as early as age 62, waiting for your benefits will increase your benefit checks. This means that a smaller portion of what you have to pay for living expenses will have to come from taxable IRA income.
As a hypothetical example of the dollar impact of using the second strategy, we can assume that a couple plans to retire at age 65. They will fund their retirement with a combination of Social Security and IRA withdrawals, totaling $70,000 after taxes. They claim the $27,700 standard deduction and use 2023 income tax brackets.
If they claim their Social Security benefits at age 65, Social Security will pay an annual total of $24,000. Eighty-five percent of that will be taxable. They must withdraw $50,777 from their retirement account and pay $4,777 in income taxes, making the total $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 per year. Now they only withdraw $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 taking Social Security. These accounts allow tax-free withdrawals. Taxpayers can also withdraw more money from traditional IRAs before claiming benefits. This spreads the tax impact over more years.
Consider a match with a financial advisor if you need help arranging your retirement income and taxes.
These popular strategies may help you avoid paying federal income taxes on all or part of your Social Security benefits, 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 offer full tax benefits.
One major potential downside that may apply no matter where you live is that converting too much pre-tax savings to a Roth IRA could now push you into a higher tax bracket. This could wipe out long-term Social Security tax savings.
Furthermore, examples like the above only work if the retired couple has sufficient financial resources to delay receiving Social Security benefits until age 70.
In addition to Roth IRA conversions and delaying Social Security, other techniques can lower your tax burden:
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Get more out of taxable investment accounts like traditional IRA and 401(k) plans before claiming Social Security. This spreads the tax impact over more years.
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If you have a traditional 401(k), take distributions before you take Social Security. You’ll pay taxes on the 401(k) money either way.
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Contribute to a health savings account (HSA). HSA distributions do not count as income for purposes of determining Social Security taxes.
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If you are married, have the higher-income spouse apply for Social Security benefits first to reduce the household’s taxable income.
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Move from high-tax states to low- or no-tax states. Some states do not tax Social Security benefits at all.
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Consider speaking to a financial advisor who can provide professional, fiduciary advice.
Social Security benefits are taxed, but there are some special tax benefits that allow retirees to reduce their overall tax burden using some popular techniques. Strategic moves like Roth IRA conversions and delaying Social Security can significantly reduce your tax burden in retirement. These techniques may require you to pay taxes in advance before retirement. And states tax Social Security in different ways, some of which may not be reduced by these measures.
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Before making important financial decisions, consider working with a financial advisor who can assess your specific situation. 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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Estimate how much you will receive from Social Security in the future using SmartAsset’s Social Security Calculator.
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Have an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that is not at risk of significant fluctuations like the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But with a high-interest account, you can earn compound interest. Compare savings accounts from these banks.
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The post You May Be Paying Too Much Tax on Your Social Security Benefits. Here’s how to lower them. appeared first on SmartReads from SmartAsset.
