One of the biggest surprises for soon-to-be retirees as they plan their retirement finances is the fact that their Social Security benefits may well be subject to income tax.
A financial advisor can help you plan for your Social Security benefits and potentially minimize your tax burden on your benefits. Contact a fiduciary advisor today.
One reason for the confusion is that they never saw their parents or grandparents paying taxes on their benefits. However, more and more pensioners are likely to pay tax on their benefits in the future. In 2022, about 48% of Social Security recipients paid federal income taxes on their benefits — a number that is expected to rise to about 56% by 2050, according to a 2015 analysis published by the Social Security Administration.
How Social Security benefits are taxed
Under rule changes first enacted by President Ronald Reagan and later expanded by President Bill Clinton, Social Security recipients may have to pay taxes on up to 85% of their benefits, depending on their other sources of income. The formula for calculating the tax is called “combined income” or “provisional income” and is not entirely simple.
You can calculate your provisional or combined income by adding half of your annual Social Security benefits to your adjusted gross income (AGI), plus any tax-free interest paid to you. From there, income brackets determine the extent to which your benefits are considered taxable income.
None of your benefits are taxable if your provisional income:
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Less than $25,000 as a single filer
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Less than $32,000 as a co-applicant
Up to 50% of your benefits are taxable if your provisional income is:
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Between $25,000 and $34,000 as a single filer
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Between $32,000 and $44,000 as a co-applicant
Up to 85% of your benefits are taxable if your pension income is:
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More than $34.00 as an individual filer
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More than $44,000 as a co-applicant
Assume you receive $2,800 a month in Social Security benefits in 2024, which means you will receive a total of $33,600 in Social Security benefits in 2024. Now imagine if you also withdraw $30,000 from an IRA. As a result, your provisional income would be $46,800 ($16,800 + $30,000). As a sole taxpayer, you would be taxed on up to 85% of your benefits because your provisional income exceeds the $34,000 threshold. According to this IRS calculator, you would pay income taxes on $15,380 of your benefits.
Remember, a financial advisor can help you better understand your tax liability in retirement, including the amount of your taxable benefits and strategies for mitigating those taxes.
How to Minimize Social Security Tax
There are several strategies you can use to potentially minimize the taxes you ultimately pay on your Social Security benefits:
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Reduce or delay pension benefits: Deferring or reducing withdrawals from an IRA, 401(k), or other tax-advantaged account will reduce or eliminate your provisional income. One strategy would be to withdraw cash from a Roth IRA or Roth 401(k), which does not count as taxable income.
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Manage your RMDs: At age 73 (or 75 for those who turn 74 after December 31, 2032), the IRS requires you to begin taking required minimum distributions (RMDs) from your IRAs, 401(k)s, and others tax-deferred accounts begin. If you are still working and have a 401(k) account at that job, you are not required to withdraw RMDs from that account. If you make a qualified charitable distribution (QCD) from an IRA, that amount can help cover your RMD but doesn’t count as taxable income.
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Roth conversion: Converting an IRA or 401(k) to a Roth IRA means you will pay income tax at the time of conversion, but qualified withdrawals in the future can be made tax-free and will not count toward your total income. However, you will likely have to pay taxes on your Social Security benefits in the year you convert tax-deferred assets. One strategy is to convert just enough money to keep your taxable Social Security benefits at 50% or 0%.
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Watch out for the “control torpedo”: Note that adding the taxable amount of your Social Security benefits to your income may result in you being placed in a higher tax bracket. This impact is known as the Social Security tax torpedo. Remember to consider all of your retirement income sources when planning your taxes. A financial advisor can also help you avoid this tax torpedo and other financial pitfalls in retirement.
Bottom line
Managing and minimizing the taxes you pay on your Social Security benefits and other retirement income can be complicated. Take the time to estimate your retirement taxes before you begin collecting pensions, Social Security, and withdrawals from retirement accounts.
Retirement planning tips
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It’s important to understand how required minimum distributions (RMDs) work and how they can affect your tax liability in retirement. These mandatory withdrawals from tax-deferred retirement accounts increase your taxable income and potentially move you into a higher tax bracket. Luckily, SmartAsset has an RMD calculator that can help you estimate how much your first RMD might be and when it will be due so you can plan ahead.
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Balancing taxes and retirement income is an important part of financial planning in retirement. A knowledgeable financial advisor can help you decide how to structure and coordinate your income plan to potentially minimize taxes. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three verified financial advisors working in your region, and you can have a free discovery call with your matching advisors to decide which one you think is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Image credits: ©iStock.com/KenTannenbaum, ©iStock.com/ljubaphoto, ©iStock.com/Thurtell
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