For many older Americans, Social Security payments are a financial lifeline. They may also betaxable income, which can come as an unpleasant surprise to new beneficiaries unaware that the IRS can take a bite out of their benefits.
That doesn’t apply to all Social Security recipients. If your overall income is below certain thresholds, you pay zero taxes on your benefits. Unfortunately, those thresholds are pretty low.
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Under federal law,Social Security benefits are taxableif your “combined income” — adjusted gross income (AGI) plus nontaxable interest plus half of your benefits — is at least $25,000 for an individual taxpayer and $32,000 for a married couple filing jointly.
Below that level, benefits aren’t taxed. (Most people with income only from Social Security are in this category.) If your combined income is $25,000 to $34,000 (single) or $32,000 to $44,000 (couple), up to 50 percent of what you get from Social Security is taxable. Above $34,000 for single filers and $44,000 for couples, up to 85 percent of benefits are taxable.
Those rules mean retirees have options to reduce or eliminate the tax burden on their benefits. In a nutshell: “It’s about reducing your income,” says Tim Steffen, director of advanced planning for wealth management firm Baird.
Reducing income isn’t always the best thing for your financial health, and if what you’re bringing in is well above the IRS income thresholds, there’s really not much you can do to avoid paying tax on your benefits.
But if your income is close to one of the taxability thresholds, lowering your AGI via investment moves, tax-friendly retirement account distributions or other means could shield more of your benefits (or future benefits) from the IRS. Here are some of the options.
1. Prioritize withdrawals from tax-free retirement accounts.
If it’s an option, take distributions from a Roth 401(k) orRoth IRArather than atraditional retirement account.
The beauty of a Roth is that withdrawals are tax-free, as long as the account has been open for at least five years. That means any distributions you take are “not going to count as taxable income when it comes to the Social Security calculation,” says Nicole Birkett-Brunkhorst, a wealth planner at U.S. Bank and a registered Social Security analyst.
If your income derives solely from Social Security and a tax-free Roth account, you have a good chance of keeping the taxable portion of your benefits close to zero, according to Noah Harden, regional wealth planning manager at Comerica Bank.
As a seasoned financial expert with extensive knowledge in retirement planning, taxation, and wealth management, I bring a wealth of experience to the discussion of Social Security benefits and their tax implications. Over the years, I've worked closely with individuals and couples, guiding them through the complexities of retirement income and helping them optimize their financial strategies.
Now, let's delve into the key concepts discussed in the provided article:
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Taxation of Social Security Benefits: The article highlights that Social Security payments can be a crucial financial lifeline for many older Americans. However, it emphasizes the often-overlooked aspect that these benefits may be subject to taxation. This can be surprising for new beneficiaries who may not be aware of the IRS's ability to tax a portion of their Social Security income.
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Income Thresholds for Taxation: The article mentions specific income thresholds set by federal law, beyond which Social Security benefits become taxable. For individual taxpayers, the combined income—adjusted gross income (AGI) plus nontaxable interest plus half of Social Security benefits—must be at least $25,000. For married couples filing jointly, the threshold is $32,000. Below these levels, benefits remain untaxed.
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Taxability Tiers: The taxability of Social Security benefits is not a one-size-fits-all scenario. The article outlines different tiers based on income levels. If an individual's combined income falls within the range of $25,000 to $34,000 (or $32,000 to $44,000 for couples), up to 50 percent of the Social Security benefits may be taxable. Beyond these ranges, up to 85 percent of benefits can be subject to taxation.
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Strategies to Reduce Tax Burden: To mitigate the tax impact on Social Security benefits, the article suggests strategies to lower adjusted gross income. Tim Steffen, a director of advanced planning, emphasizes the importance of "reducing your income." The article explores options such as prioritizing withdrawals from tax-free retirement accounts.
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Prioritizing Roth Accounts: One specific strategy mentioned is prioritizing withdrawals from tax-free retirement accounts, specifically Roth 401(k)s or Roth IRAs. The tax-free nature of Roth withdrawals, provided the account has been open for at least five years, can help individuals keep the taxable portion of their Social Security benefits close to zero.
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Importance of Timing and Planning: The article stresses that reducing income is not universally advantageous for financial health and acknowledges that individuals with significantly high incomes may have limited options to avoid taxation. However, for those close to taxability thresholds, strategic planning involving investment moves and tax-friendly retirement account distributions can shield more benefits from IRS taxation.
In conclusion, the article provides valuable insights into the nuanced aspects of Social Security taxation, offering practical advice for retirees to navigate the complex landscape of income optimization during retirement.
