How To Manage Taxes on Your Social Security Benefits in Retirement

How To Manage Taxes on Your Social Security Benefits in Retirement

Social Security benefits are a critical source of income for many retirees, but did you know that your benefits might be subject to federal taxes? Understanding how Social Security is taxed and learning strategies to reduce the tax burden on these benefits can make a significant difference in your retirement income.

In this blog, we’ll break down the factors that determine whether your Social Security benefits are taxed, how the tax calculations work, and what steps you can take to minimize the amount of taxes you pay on your benefits during retirement.

Are Social Security Benefits Taxable?

Yes, Social Security benefits can be taxable, but it depends on your overall income during retirement. The IRS uses what’s called your "combined income" to determine whether a portion of your benefits will be subject to taxation.

Combined income is calculated using the following formula:

CombinedIncome=AdjustedGrossIncome(AGI)+NontaxableInterest+50%ofYourSocialSecurityBenefits\text{Combined Income} = \text{Adjusted Gross Income (AGI)} + Nontaxable Interest + 50\% of Your Social Security BenefitsCombinedIncome=AdjustedGrossIncome(AGI)+NontaxableInterest+50%ofYourSocialSecurityBenefits

If your combined income exceeds certain thresholds, a portion of your Social Security benefits will be subject to federal income tax. These thresholds are relatively low, which means that many retirees find themselves paying taxes on part of their benefits.

Income Thresholds for Social Security Benefit Taxation

The IRS sets different income thresholds for determining whether Social Security benefits are taxable, based on your filing status:

• For single filers:
  • If your combined income is between $25,000 and $34,000, up to 50% of your Social Security benefits may be taxed.
  • If your combined income exceeds $34,000, up to 85% of your benefits may be taxable.
• For married couples filing jointly:
  • If your combined income is between $32,000 and $44,000, up to 50% of your benefits may be taxed.
  • If your combined income exceeds $44,000, up to 85% of your benefits may be taxable.

If you’re married but file separately, your benefits are likely to be taxed at the 85% level regardless of your income.

How Are Social Security Benefits Taxed?

Once you determine that part of your Social Security benefits is taxable based on your combined income, the taxable portion will be included in your gross income for the year and taxed at your marginal income tax rate. The actual tax owed depends on where your taxable income falls within the federal tax brackets.

For example, if you’re in the 12% tax bracket, the taxable portion of your Social Security benefits will be taxed at that rate. If you have other income that pushes you into a higher bracket, part of your benefits may be taxed at a higher rate.

Strategies to Minimize Taxes on Social Security Benefits

The good news is that there are several strategies you can use to reduce or avoid taxes on your Social Security benefits. By managing your retirement income wisely, you may be able to stay below the income thresholds or reduce the portion of your benefits subject to taxes. Below are some key strategies to consider:

1. Delay Social Security Benefits

One of the most effective strategies for reducing taxes on your Social Security benefits is to delay taking them. You can start claiming Social Security as early as age 62, but if you wait until full retirement age (66 or 67, depending on when you were born), your benefits will be higher.

If you delay further, until age 70, your benefits will increase even more due to delayed retirement credits. Higher monthly benefits from delaying Social Security may reduce the need to rely on other income sources that push your combined income above the taxation threshold.

2. Manage Withdrawals From Tax-Deferred Accounts

Tax-deferred retirement accounts, such as traditional IRAs and 401(k)s, are subject to income tax when you make withdrawals. Because these withdrawals count toward your combined income, they can increase the taxable portion of your Social Security benefits.

To minimize taxes, you can strategically time withdrawals from tax-deferred accounts. For example, in the years before you start collecting Social Security, you might withdraw more from your tax-deferred accounts to reduce the balance. Once you start taking Social Security, you could reduce your withdrawals from these accounts to lower your taxable income.

Alternatively, if your income is low early in retirement, you could consider converting some of your traditional IRA or 401(k) funds to a Roth IRA, which allows for tax-free withdrawals later in retirement.

3. Use Roth Accounts for Tax-Free Income

Roth IRAs and Roth 401(k)s offer tax-free income in retirement because you contribute after-tax dollars to these accounts. Withdrawals from Roth accounts don’t count toward your combined income, which means they won’t affect the taxation of your Social Security benefits.

If you have a mix of taxable, tax-deferred, and tax-free accounts, drawing from your Roth accounts can help you manage your combined income and keep more of your Social Security benefits tax-free.

4. Control Taxable Investment Income

Interest, dividends, and capital gains from taxable investment accounts contribute to your combined income. If you’re drawing Social Security and also earning significant income from investments, it could push you over the threshold for taxing your benefits.

Consider managing your taxable investment income through strategies such as tax-loss harvesting (selling investments at a loss to offset gains) or holding investments for longer periods to take advantage of lower long-term capital gains rates. You could also consider shifting to tax-efficient investments, such as municipal bonds, which generate nontaxable interest.

5. Maximize Deductions and Credits

Maximizing deductions and tax credits can help reduce your overall tax liability, potentially lowering the taxable portion of your Social Security benefits. Common deductions for retirees include charitable contributions, medical expenses, and property taxes. If you itemize deductions, you may be able to reduce your taxable income and keep your combined income below the Social Security tax thresholds.

Additionally, take advantage of tax credits such as the Retirement Savings Contribution Credit (Saver’s Credit) if you qualify. Credits directly reduce your tax bill, which can help mitigate the impact of taxes on your Social Security benefits.

Understanding State Taxes on Social Security

In addition to federal taxes, some states also tax Social Security benefits, while others do not. As of now, 38 states do not tax Social Security income. However, the following 12 states do:

• Colorado
• Connecticut
• Kansas
• Minnesota
• Missouri
• Montana
• Nebraska
• New Mexico
• Rhode Island
• Utah
• Vermont
• West Virginia

Each of these states has different rules regarding how Social Security is taxed, and some offer exemptions based on income. If you live in a state that taxes Social Security, it’s important to understand the specific rules and explore ways to minimize your state tax liability.

How to Plan for Taxes on Social Security Benefits

Planning for the taxation of your Social Security benefits requires a combination of tax-efficient strategies and proactive income management. Here are some steps you can take to better plan for taxes on your Social Security benefits:

1. Estimate Your Combined Income: Before claiming Social Security, estimate your combined income to determine how much of your benefits will be taxable. Consider all sources of income, including tax-deferred accounts, taxable investments, and other retirement income.
2. Work With a Financial Advisor: A financial advisor can help you create a comprehensive tax plan that includes Social Security. They can help you decide when to claim benefits, how to manage withdrawals from retirement accounts, and how to take advantage of tax-saving strategies.
3. Use IRS Tools: The IRS provides tools such as the Social Security Benefits Worksheet, which can help you calculate how much of your benefits will be subject to taxes. It’s a good idea to use this worksheet each year as part of your tax planning process.
4. Adjust Your Withholding: If you expect a significant portion of your Social Security benefits to be taxed, you can request that federal taxes be withheld from your benefits. This can help you avoid a large tax bill when you file your taxes. You can set up withholding by filing IRS Form W-4V with the Social Security Administration.
5. Stay Informed: Tax laws and Social Security rules can change over time, so it’s important to stay informed about any updates that may affect how your benefits are taxed. Regularly reviewing your financial plan and tax strategy can help you adapt to any changes and continue to minimize your tax burden in retirement.