For many older Americans, Social Security payments are a financial lifeline. They can also be taxable income, which can come as an unpleasant surprise to new beneficiaries unaware that the IRS can take a bite out of their benefits.
This does not apply to all social security recipients. If your total income is below certain thresholds, you pay zero tax on your distribution. Unfortunately, those thresholds are quite low.
Under federal law, Social Security benefits are taxable if your “combined income” — adjusted gross income (AGI) plus nontaxable interest plus half of your benefits — is at least $25,000 for an individual taxpayer and $32,000 for a married couple who joint application.
Benefits below that level are not taxed. (Most people with only Social Security income fall into this category.) If your combined income is $25,000 to $34,000 (single) or $32,000 to $44,000 (couple), up to 50 percent of what you take from Social Security is secured, taxable. Above $34,000 for single filers and $44,000 for couples, up to 85 percent of the benefits are taxable.
Those rules mean retirees have options to reduce or eliminate the tax burden on their benefits. In a nutshell, “It’s about reducing your income,” says Tim Steffen, director of advanced planning for wealth management firm Baird.
Cutting income isn’t always best for your financial health, and if what you’re bringing in is well above the IRS income thresholds, there’s not much you can do to avoid paying taxes on your distributions.
But if your income is close to one of the taxability thresholds, lowering your AGI through investment moves, tax-friendly retirement benefits, or other means can protect more of your benefits (or future benefits) from the IRS. Here are some of the options.
1. Prioritize withdrawals from tax-free retirement accounts.
If it’s an option, take distributions from a Roth 401(k) or Roth IRA instead of a traditional retirement account.
The beauty of a Roth is that withdrawals are tax free as long as the account has been open for at least five years. That means any distributions you take “will not count as taxable income when it comes to calculating Social Security,” says Nicole Birkett-Brunkhorst, an wealth planner at U.S. Bank and a registered Social Security analyst.
If your income comes solely from Social Security and a tax-exempt Roth account, you stand a good chance of keeping the taxable portion of your distributions close to zero, according to Noah Harden, regional estate planning manager at Comerica Bank.