Social Security plays a critical role in the retirement plans of millions of Americans, but how these benefits are taxed is sometimes overlooked. If you collect $2,700 per month in Social Security benefits, your check is well above the average retirement benefit of approximately $1,800 per month and it could mean that you’ll owe taxes on this money. However, there are ways to potentially reduce your tax liability. Consider working with a financial advisor to create a comprehensive financial plan for retirement that accounts for your Social Security benefits and tax situation.
How Do Social Security Benefit Taxes Work?
Social Security benefit taxes are calculated based on “combined income.” As your combined income climbs, you’ll potentially owe taxes on a larger percentage of your benefits. Here’s how combined income gets calculated:
- Adjusted gross income
- + Nontaxable interest
- + Half of your Social Security benefits
So, for example, say that you withdraw $50,000 from your 401(k) and collect $40,000 in annual Social Security benefits. Your combined income would be $70,000 ($50,000 + $40,000/2).
From there, the IRS uses the following income tiers to tax the benefits of people who file their taxes as individuals:
- Combined income below 25,000: Benefits are not taxable
- Combined income between $25,000 and $34,000: Up to 50% of benefits are taxable
- Combined income above $34,000: Up to 85% of benefits are taxable
If you file a joint return with your spouse, the following income tiers will determine the taxability of your Social Security:
- Combined income below $32,000: Benefits are not taxables
- Combined income between $32,000 and $44,000: Up to 50% of benefits are taxable
- Combined income above $44,000: Up to 85% of benefits are taxable
Note that these are not the tax rates. Rather, this means that up to 50% or up to 85% of your Social Security benefits are subject to your ordinary income tax rates. But if you need help assessing your tax liability, consider speaking with a financial advisor with tax expertise.
Reducing Your Benefit Taxes
As we mentioned above, the more combined income you have, the more of your benefits can potentially be taxed. If you collect $2,700 per month, that’s $32,400 per year in Social Security benefits, which gives you a starting combined income of $16,200 ($32,400/2). If Social Security were your sole source of income, you wouldn’t owe any taxes on your benefits.
From there, taxes will apply depending on your other sources of income. For example, say that you withdraw $50,000 from your 401(k). That would make your combined income $66,200 (50,000+16,200), meaning up to 85% of your benefits – $27,540 – would be taxable.
So here are a few strategies to potentially reduce your taxes.
Withdraw Less From Your Portfolios
The first possibility is to manage your retirement account withdrawals. This depends entirely on your retirement budget and lifestyle, but the less you withdraw the more you can stay under the IRS’s tax caps.
In this case, you start with a combined income of $16,200. If you withdraw less than $8,800 ($15,800 if you’re married and file jointly) from your retirement accounts, your combined income will not trigger taxes on your benefits. If you withdraw less than $17,800 ($27,800 if you’re married) in additional income, you will only pay taxes on up to half of your benefits. The trouble, of course, is that this might require living on an unrealistically tight budget. Keep in mind that a financial advisor can help you build a budget and income plan for retirement.
Structure Roth Withdrawals
Perhaps a more realistic way to manage your retirement withdrawals is to rely on Roth accounts. The money you take from a Roth IRA or a Roth 401(k) does not add to your taxable income for the year, so these withdrawals won’t impact your combined income. This leads to two potential strategies.
First, you can maximize Roth withdrawals. By taking all of your retirement income from a Roth account, your combined income will stay at $16,200.
However, this approach may drain your Roth portfolios too quickly. Instead, you could structure your Roth withdrawals around the Social Security tiers. By doing this, you would limit your withdrawals from tax-deferred accounts so that your combined income stays below the 50% or 85% threshold. You’d then use Roth accounts for any withdrawals that would otherwise trigger these higher thresholds.
For example, say that you want to withdraw $50,000 per year in additional retirement income. You could withdraw $17,799 from a traditional IRA and $32,201 from a Roth IRA. This would give you a combined income of $33,999, ensuring that only 50% of your benefits are taxable.
And if you need help with Roth conversions or managing your Roth accounts, consider working with a financial advisor.
Defer Social Security Benefits
You could also defer your Social Security benefits, living entirely off portfolio withdrawals during your 60s. Then, you could begin collecting Social Security at age 70 when your benefit maxes out.
You wouldn’t pay taxes on the benefits that you have deferred. At age 70, you would collect increased benefits and would reduce the amount of money you’d need to withdraw from your portfolio. This would have the effect of reducing your annual combined income by thousands of dollars. However, it would require having enough money in your retirement accounts and additional planning to ensure you won’t run out of money later in life.
Social Security benefits taxes are based on your household’s taxable income. How much of your benefit is subject to taxes is largely based on three tiers – 0%, 50% or 85%. However, you can potentially reduce your taxes on Social Security through structured portfolio withdrawals, Roth conversions or simply withdrawing less.
Social Security Benefits Tips
- Planning for Social Security is critical. If you need help estimating how much your benefits will be so you can decide when to claim them, SmartAsset’s Social Security calculator is a good tool to use.
- A financial advisor can help you plan for Social Security and make other financial decisions that may impact your tax liability in retirement. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Photo credit: ©iStock.com/PeopleImages, ©iStock.com/mphillips007, ©iStock.com/AJ_Watt