The taxation of Social Security benefits, once a non-entity, has become a significant concern for many retirees. To give you an idea of the gravity of the situation, in 1983, when Congress decided to impose a tax on Social Security benefits for high-income recipients, less than 10% of beneficiaries were affected. Fast forward to today, inflation has surged, but the law hasn't been updated, resulting in most Social Security beneficiaries paying federal income tax on a portion of their benefits.
The purpose of this article is to provide an extensive guide on how to avoid the 'tax torpedo' associated with Social Security benefits and keep more of those hard-earned dollars in your pocket.
Understanding Social Security Taxes
Social Security taxes are calculated based on your annual 'combined income'. This income comprises:
Adjusted Gross Income (AGI): This includes your earnings, income from investments, withdrawals from retirement plans, and other taxable income.
Nontaxable Interest: Such as the interest received on municipal bonds.
Half of your Social Security Benefits.
For couples filing a joint return, if their combined income lies between $32,000 and $44,000, up to 50% of their benefits may be taxed. Up to 85% of the benefits may be taxed for higher combined incomes. Single filers may end up paying tax on up to 50% of benefits when their combined income lies between $25,000 and $34,000 and up to 85% of benefits beyond that.
People who live solely on Social Security don't have to pay income taxes on their benefits. But any additional income, even a relatively small amount, can make benefits taxable.
The Tax Torpedo
The unique way Social Security benefits are taxed gives rise to what is known as the 'tax torpedo' – a sharp increase in marginal tax rates followed by a decline. Marginal tax rates are what you pay on each additional dollar of taxable income you receive. Due to this tax torpedo, many middle-income households can face marginal tax rates that are 50% to 85% higher than their regular tax bracket.
Defusing the Tax Torpedo
Moderate-income households may be able to mitigate the effects of the tax torpedo by delaying the start of Social Security benefits as long as possible. Someone who waits until age 70 to start benefits while withdrawing money from retirement funds in the meantime not only gets a more extensive Social Security check but could also save hundreds or even thousands of dollars a year in taxes. If you're in the 10% to 22% federal tax brackets, consider consulting a tax professional or financial planner about mitigating the potential tax burden.
Contributing to a Roth
Having some money in a Roth IRA or Roth 401(k) can help reduce taxes on Social Security benefits. Withdrawals from these accounts are tax-free in retirement and not included in your combined income. It's crucial to diversify retirement accounts long before you stop working, as you can't contribute to a retirement account if you don't have earned income.
Getting Charitable with Your IRA
Once you're 70 1/2, you can make qualified charitable distributions, such as donations from your IRA to a charity. The withdrawal isn't taxable and won't count in your combined income if the money is transferred directly from the IRA custodian to the charity.
Other Ways to Reduce Distributions
Required Minimum Distributions (RMDs) can push you into a higher tax bracket and trigger higher Social Security taxes if you've been a diligent saver. Tapping your retirement funds before you're forced to do so or a Roth conversion could make sense. With a conversion, money is transferred to a Roth IRA from a pretax retirement account such as an IRA or 401(k). Conversions typically incur taxes, but withdrawals in retirement are tax-free.
Avoiding the pitfalls of unnecessary taxes, increased Medicare or Affordable Care Act premiums, and other financial repercussions, such as running out of money prematurely, requires careful planning. The goal is to smooth out your tax rates – you don't want years where you're paying at a much higher rate and years where you're paying zero.
This guide was provided to help you navigate the complex landscape of Social Security benefits taxation. The key takeaway is that informed decisions and careful planning can help you avoid the tax torpedo, ultimately ensuring a more comfortable and secure retirement.