Taxes can be a big concern in retirement because no matter how well you’ve saved and invested during your working years your challenge is to keep as much of it as possible. That means structuring your finances, withdrawals and income in a way that minimizes how much you fork over to the IRS.
Take Social Security. Just because grandma and grandpa and mom and dad didn’t pay taxes on their benefits doesn’t mean you won’t. In fact, it’s quite likely that you’ll pay tax on 50% or even 85% of your benefits. When the rule taxing benefits went into effect in 1984, very few Social Security recipients saw their payments taxed. Now, it’s nearly half of all recipients and that percentage goes up each year.
Your personal tax situation will depend on many factors. Get matched with a financial advisor who can help you understand the nuances.
Income Limits Trigger Taxes
Whether – and how much – your benefits are taxed depends on your other taxable income during the year, including pension payments, withdrawals from taxable retirement accounts, interest payments, gambling winnings or any other taxable source. Calculate your adjusted gross income, add half your annual Social Security payments plus any nontaxable interest you receive, and if you go over the set-in-stone income limits, your benefits are taxable to a certain extent.
Social Security benefits aren’t taxed if combined income is:
- Less than $25,000 for single filers
- Less than $32,000 for joint filers
Up to 50% of benefits are taxed if combined income is:
- Between $25,000 and $34,000 for single filers
- Between $32,000 and $44,000 for joint filers
Up to 85% of benefits are taxed if combined income is:
- More than $34,00 for single filers
- More than $44,000 for joint filers
For a single filer with monthly benefits of $2,500, that means you can’t have other income of more than $10,000 before you hit the 50% tax range ($2,500 x 12 x 1/2 + $10,000 = $25,000). If you have $19,000 or more, you’ll step up to the 85% bracket. Naturally, you’ll want to shrink that tax bite. Here are a few strategies.
Ways to Reduce Social Security Taxes
Roth Conversion
Converting a tax-deferred IRA or 401(k) to a Roth IRA means you’ll pay income tax on the amount converted but Roth withdrawals don’t count toward your combined income, leaving your Social Security untaxed. You also won’t pay tax on future gains in the Roth, and you’ll avoid the dreaded required minimum distribution (RMD), which can also leave your benefits taxable. If you can convert before filing for Social Security, the converted amounts won’t result in taxes on your benefits.
Talk to a financial advisor about developing a fully integrated retirement plan that accounts for income, taxes and more.
Draw Down Accounts and Delay SS
By taking withdrawals from taxable accounts and postponing Social Security you not only reduce or avoid paying tax on your benefits, but you also get an 8% increase in your payment for every year after your full retirement age and age 70.
Use Nontaxable Income Sources
Keeping your taxable income low allows you to sidestep taxes on your benefits. This can include using up cash reserves or selling investments that have little or no capital gains, or where capital gains are offset by capital losses. Another option can be payments from annuities purchased with after-tax dollars, where only gains, dividends and interest are taxable. However, you want to weigh the long-term tradeoffs of this strategy before implementing, as tax-free accounts like a Roth IRA may be more beneficial down the line.
Give to Charity
Once your turn 73 (or 75 for those born after 1960) the IRS insists that you start taking RMDs from IRAs. If you don’t need that cash for living expenses you can use your RMD to make a qualified charitable deduction to a worthy cause. Make sure the charity qualifies and that the donation goes directly from your IRA to the charity, or it will count as a taxable distribution. The rules surrounding RMDs are plentiful, but their impact can often be mitigated with proper planning. Consider getting matched with a financial advisor for guidance.
Bottom Line
We all want to pay as little in taxes as possible. This is especially true in retirement when most of us have a set amount of savings. But if you have enough retirement income that you’re paying taxes on Social Security, you’re probably doing well. It means you have income from other sources and you’re not entirely dependent on Social Security to meet living expenses. You can also save on your taxes in retirement simply by having a plan.
Tips
- A financial advisor can help you build a retirement income plan. 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.
- To calculate your potential taxes on Social Security, check the “Are My Social Security or Railroad Retirement Tier I Benefits Taxable?” on the IRS website.
- Keep an emergency fund on hand in case you run into unexpected expenses. An emergency fund should be liquid — in an account that isn’t at risk of significant fluctuation like the stock market. The tradeoff is that the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.
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