3 Ways to Reduce the Taxes You Pay on Benefits
For most Americans, Social Security is taxable. That is, a majority of those who receive Social Security benefits pay income tax on up to half or even 85% of that money because their combined income from Social Security and other sources pushes them above the very low thresholds for taxes to kick in.
2. Consider withdrawing some money from your taxable retirement fund after you’re 59 1/2 but before you retire. Depending on what your income and deductions look like before and after, you could pay a little more taxes in advance to avoid paying a lot more taxes later.
3. Consider putting your retirement money into a deferred annuity. More on that later; It’s a big decision with implications beyond taxes.
a. Up to 50% of Social Security income is taxable for individuals with a total gross income including Social Security of at least $25,000, or couples filing jointly with a combined gross income of at least $32,000.
b. Up to 85% of Social Security benefits is taxable for an individual with a combined gross income of at least $34,000, or a couple filing jointly with a combined gross income of at least $44,000.
c. Retirees who have little income other than Social Security won’t be taxed on their benefits. In fact, you may not even have to file a return.
d. Your focus should be on paying less overall taxes on your combined income.
e. A tax-advantaged retirement account like a Roth IRA can help.
Social Security payments have been subject to taxation above certain income limits since 1983.1 No inflation adjustments have been made to those limits since then, so most people who receive Social Security benefits and have other sources of income pay some taxes on the benefits.
1. The calculation begins with your adjusted gross income from Social Security and all other sources. That may include wages, self-employed earnings, interest, dividends, required minimum distributions from qualified retirement accounts, and any other taxable income.
2. Then, any tax-exempt interest is added. (No, it isn’t taxed, but it goes into the calculation.)
3. If that total exceeds the minimum taxable levels, at least half of your Social Security benefits will be considered taxable income. You then have to take the standard deduction or itemize deductions in order to arrive at your net income.
The amount you owe depends on precisely where that number lands in the federal income tax tables.
Benefits will be subject to tax if you file a federal tax return as an individual and your combined gross income from all sources is as follows:
a. Between $25,000 and $34,000: You may have to pay income tax on up to 50% of your benefits.
b. More than $34,000: Up to 85% of your benefits may be taxable.
The Internal Revenue Service (IRS) has a worksheet that can be used to calculate your total income taxes due if you receive Social Security benefits. When you complete this typically long-winded exercise in arithmetic, you will find that your taxable net income has increased by up to 50% of the amount you received from Social Security If your gross income exceeds $25,000 for an individual or $32,000 for a couple. The percentage taxed rises to 85% of your Social Security payment if your gross income exceeds $34,000 for an individual or $44,000 for a couple.
For example, say you were an individual taxpayer who received the average amount of Social Security, $16,608, in 2019. You had $20,000 in “other” income. Add the two together and you have a gross income of $36,608. That’s well above the minimum, so half of your Social Security, or $8,304, is considered taxable income.
Your net income will be based on half of your Social Security income ($8,304) plus all of your other income ($20,000), minus the standard deduction or your itemized deductions. (Of course, it can get more complicated for some taxpayers, but we’ll keep this example simple.)
For this example, we’ll take the standard deduction of $12,200 for 2019.
Your taxable income is therefore $16,104 ($28,304 – $12,200)
Your tax in 2019 would have been $1,741, according to the 2019 tax tables. If none of your Social Security had been taxed, your taxable income would drop to $7,800 ($20,000 – $12,200) and you would owe $783. You’ve just paid back $958 of your Social Security income.
The arithmetic gets a bit more complicated if your income is above $34,000, putting you in that 85% Social Security taxable category. You’ll need the IRS worksheet.
For couples who file a joint return, your benefits will be taxable if you and your spouse have a combined income that is as follows:2
a. Between $32,000 and $44,000: You may have to pay income tax on up to 50% of your benefits.
b. More than $44,000: Up to 85% of your benefits may be taxable.
This being the IRS, the straightforward example above may not apply to you. This Interactive Tax Assistant will lead you through the various complications that are possible and calculate what part of your income is taxable.
An IRS Notice describes the tax rules for benefits.
The rules for the spousal benefit are the same as for all other Social Security recipients. If your income is above $25,000, you will owe taxes on up to 50% of the benefit amount. The percentage rises to 85% if your income is above $34,000.
Survivor benefits paid to children are rarely taxed because few children have other income that reaches the taxable ranges. The parents or guardians who receive the benefits on behalf of the children do not have to report the benefits as income.
Social Security disability benefits follow the same rules on taxation as the Social Security retiree program. That is, benefits are taxable if the recipient’s gross income is above a certain level. The current threshold is $25,000 for an individual and $32,000 for a couple filing jointly.
Supplemental Security Income (SSI) is not Social Security but a needs-based program for people who are aged, disabled, or blind. SSI benefits are not taxable.
You should get a Social Security Benefit Statement (Form SSA-1099) each January, detailing the amount in benefits you received during the previous tax year. You can use it to determine whether you owe federal income tax on your benefits. The information is available online if you enroll on the Social Security site.
If you owe taxes on your Social Security benefits, you can make quarterly estimated tax payments to the IRS or have federal taxes withheld from your payouts before you receive them.
There are 13 states which tax Social Security benefits in some cases. If you live in one of those states—Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont, and West Virginia—check with the state tax agency. As with the federal tax, how these agencies tax Social Security varies by income and other criteria.
You probably won’t owe tax on your Social Security benefits if you have little or no other income to report. The average benefit paid out as of Jan. 2020 was about $1,384 per month or $16,608 annually. That’s below the income levels noted above.
However, the maximum possible benefit as of 2020 was $3,790 for a person filing at age 70. That’s $45,480 a year, which is well into the taxable range.
The simplest way to keep your Social Security benefits free from income tax is to keep your total combined income so low it falls below the thresholds to pay tax. However, few choose to live in poverty just to minimize their taxes.
A more realistic goal is to limit how much tax you owe. Here’s a rundown of three solutions:
Contributions made to a Roth IRA or Roth 401(k) are in after-tax dollars, which means they’re not subject to tax when the funds are withdrawn. You take taxable distributions from a traditional IRA or 401(k) plan. Your distributions from a Roth IRA are tax-free.
That means the Roth payout won’t affect your taxable income calculation. That means it won’t increase the tax you owe on your Social Security benefits.
This advantage makes it wise to consider a mix of regular and Roth retirement accounts well before retirement age. The blend will give you greater flexibility to manage the withdrawals from each account and minimize the taxes you owe on your Social Security benefits.
A similar effect can be achieved by managing your withdrawals from conventional savings, money market accounts, or tax-sheltered accounts.
Another way to minimize your taxable income when drawing Social Security is to maximize, or at least increase, your taxable income in the years before you begin to receive benefits.
For example, you could withdraw funds a little early—or “take distributions,” in tax jargon—from your tax-sheltered retirement accounts such as IRAs and 401(k)s. You can make distributions penalty-free after age 59½. That means you avoid being dinged for making these withdrawals too early, but you must still pay income tax on the amount you withdraw.
Since the withdrawals are taxable (unless it’s a Roth account), they must be planned carefully with an eye on the other taxes you will pay that year. The goal is to pay less in tax by making more withdrawals during this pre-Social Security period than you would after you begin to draw benefits. That requires considering the total tax bite from withdrawals, Social Security benefits, and any other sources.
Be mindful, too, that at age 72, you’re required to take minimum distributions from these accounts, so you need to plan for those mandatory withdrawals.
This strategy has another benefit. By using these distributions to boost your income when you’re retired or nearing retirement, you might be able to delay applying for Social Security benefits. And that will increase the size of the payments.
QLACs provide monthly payments for life and are shielded from the downturns of the stock market. As long as the annuity complies with Internal Revenue Service (IRS) requirements, it is exempt from the required minimum distribution rules until payouts begin after the specified annuity starting date.
By limiting distributions, and thus taxable income, during retirement, QLACs can help minimize the tax bite taken from your Social Security benefits. Under the current rules, an individual can spend 25% or $135,000 (whichever is less) of a retirement savings account or IRA to buy a QLAC with a single premium. The longer an individual lives, the longer the QLAC pays out.
QLAC income can be deferred until age 85. A spouse or someone else can be a joint annuitant, meaning that both named individuals are covered regardless of how long they live.
Keep in mind that a QLAC shouldn’t be bought just to minimize taxes on Social Security benefits. Retirement annuities have both advantages and disadvantages that should be weighed carefully, preferably with help from a retirement advisor.
Add up your gross income for the year, including Social Security. If you have little or no income in addition to your Social Security, you won’t owe taxes on it. If you’re an individual filer and had at least $25,000 in gross income including Social Security for the year, up to 50% of your Social Security benefits may be taxable. For a couple filing jointly, the minimum is $32,000. If your gross income is $34,000 or more, up to 85% may be taxable. The minimum for a couple is $44,000.
At this writing, 37 states do not impose taxes on Social Security benefits. The other 13 tax some recipients under some circumstances.
Yes, but you can minimize the amount you owe each year by making some wise moves before and after you retire. Consider investing some of your retirement savings in a Roth account, to shield your withdrawals from income tax. Take out some retirement money after you’re 59 1/2 but before you retire, to take care of the taxes before you need the money. And, you might talk to a financial planner about a retirement annuity.
Most advice on Social Security benefits focuses on when you should start taking benefits. The short answer, these days, is to wait until you’re 70 to maximize the amount you get. But there’s another big consideration, and that’s how to prevent your Social Security benefits from taking a big bite out of your overall retirement income. And the answer to that is to plan well in advance to minimize your overall tax burden during your retirement years.
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