Social Security benefits used to be exempt from taxes until 1983 when Congress decided to tax a portion of benefits for high-income recipients. However, this change did not account for inflation, leading to the majority of Social Security beneficiaries now having to pay federal income tax on at least some of their benefits, according to Ted Sarenski, author of American Institute of CPA’s “Guide to Social Security Planning.”
To reduce the tax burden, there are several strategies you can employ, especially if you plan ahead. The taxation of Social Security benefits is based on your annual “combined income,” which includes your adjusted gross income (including earnings, investment income, retirement plan withdrawals, and other taxable income), any nontaxable interest, and one half of your Social Security benefits.
For couples filing jointly, a combined income between $32,000 and $44,000 may result in up to 50% of benefits being taxable, while higher combined incomes could result in up to 85% of benefits being taxable. Single filers may face taxes on up to 50% of benefits with a combined income between $25,000 and $34,000, and up to 85% beyond that.
It’s important to note that those living solely on Social Security income do not have to pay taxes on their benefits. However, even a small amount of additional income can cause benefits to become taxable.
The unique way in which Social Security benefits are taxed has created what’s known as the “tax torpedo.” This is a significant increase in marginal tax rates followed by a decline. William Reichenstein, professor emeritus at Baylor University, suggests that many middle-income households face marginal tax rates that are 50% to 85% higher than their regular tax bracket due to this tax torpedo.
One strategy to mitigate this effect is delaying the start of Social Security benefits as long as possible. By withdrawing money from retirement funds in the meantime, individuals not only receive a larger Social Security check but can also save hundreds or even thousands of dollars in taxes each year.
Contributing to a Roth IRA or Roth 401(k) can also help reduce taxes on Social Security benefits. Withdrawals from these accounts are tax-free in retirement and are not included in your combined income.
Another option is to make qualified charitable distributions from your IRA once you reach 70 ½ years old. These donations to charities are not taxable and do not count toward your combined income, as long as the money is transferred directly from the IRA custodian to the charity.
For those who have been diligent savers, required minimum distributions (RMDs) from retirement accounts can push them into a higher tax bracket and trigger higher Social Security taxes. Tapping into retirement funds before being forced to do so or considering a Roth conversion can help mitigate this. However, it’s essential to consult with a tax professional or financial planner to avoid unnecessary taxes and other financial repercussions.
In summary, understanding how Social Security benefits are taxed and utilizing strategies such as delaying benefits, contributing to Roth accounts, making qualified charitable distributions, and carefully planning retirement account withdrawals can help reduce the tax burden on your Social Security benefits.
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