Social Security benefits used to be entirely exempt from taxation until 1983 when Congress introduced a change to tax a portion of benefits for those with the highest incomes. Initially, this change affected less than 10% of beneficiaries. However, lawmakers neglected to adjust the law for inflation.
Notably, individuals who rely solely on Social Security as their income source are generally exempt from income taxes on their benefits, as highlighted. However, even a modest amount of additional income can trigger taxation on Social Security benefits.
Understanding Social Security Taxation
For couples filing a joint return, a combined income falling within the range of $32,000 to $44,000 can result in up to 50% of their benefits being subject to taxation. For those with higher combined incomes, up to 85% of their benefits may be taxable.
Single filers could face taxes on up to 50% of their benefits when their combined income falls between $25,000 and $34,000, with up to 85% of benefits being taxable beyond that threshold. Social Security taxes are determined by your annual “combined income,” which consists of:
- Your adjusted gross income, encompassing earnings, investment income, retirement plan withdrawals, and other taxable sources of income.
- Any non-taxable interest you receive, such as interest earned on municipal bonds.
- Half of your Social Security benefits.
Mitigating the Tax Torpedo
The unique taxation of Social Security benefits can trigger what experts refer to as the “tax torpedo.” This phenomenon, characterized by a sudden increase in marginal tax rates followed by a decrease, is described by William Reichenstein, a professor emeritus at Baylor University and co-author of “Social Security Strategies: How to Optimize Retirement Benefits.” Marginal tax rates indicate the tax you pay on each additional dollar of taxable income.
For many middle-income households, the tax torpedo can lead to marginal tax rates that are 50% to 85% higher than their regular tax bracket. As Reichenstein explains, withdrawing an additional dollar from your tax-deferred account can result in an additional 85 cents of Social Security becoming taxable, effectively increasing your taxable income by $1.85.
Moderate-income households can potentially defuse the tax torpedo’s impact by delaying the commencement of Social Security benefits for as long as possible. By waiting until age 70 to start receiving benefits and utilizing retirement funds in the interim, individuals not only receive larger Social Security payments but could also save substantial sums in annual taxes, possibly totaling hundreds or even thousands of dollars, according to Reichenstein’s advice. If you fall within the 10% to 22% federal tax brackets, it may be prudent to consult with a tax professional or financial planner to explore strategies for mitigating potential tax burdens.
Consider Contributing to a Roth Account
Allocating some of your savings into a Roth IRA or Roth 401(k) can be a strategic move to minimize taxes on your Social Security benefits. These accounts offer the advantage of tax-free withdrawals during retirement and are not factored into your combined income, as highlighted by Sarenski.
It’s important to note that you can only contribute to a retirement account if you have earned income. Therefore, it’s wise to diversify your retirement accounts well before your retirement years. Placing all your funds into a pretax option might result in substantial tax obligations down the road.
Ideally, individuals should aim to strike a balance between their pretax and after-tax income sources, allowing them to manage their tax liabilities more effectively in the future when they retire.
Support Charities Using Your IRA
Once you reach the age of 70½, you have the option to engage in qualified charitable distributions, which involve making charitable donations directly from your IRA to a charitable organization. The withdrawals from your IRA in this manner are not subject to taxation, and they do not contribute to your combined income, provided that the funds are transferred directly from the IRA custodian to the charity. You can transfer a maximum of $100,000 using this method.
For those who have reached the age at which required minimum distributions (RMDs) from retirement accounts must commence – presently, that age is 73 – it’s worth noting that qualified charitable distributions can fulfill your RMD requirement.
Exploring Alternative Strategies to Reduce Mandatory Distributions
If you’ve diligently saved for retirement, required minimum distributions (RMDs) can potentially push you into a higher tax bracket and lead to increased Social Security taxes, as noted by Sarenski.
To mitigate these impacts, it may be prudent to consider tapping into your retirement funds before you are compelled to do so, or exploring a Roth conversion, suggests Sarenski. A Roth conversion involves transferring funds from a pretax retirement account, such as an IRA or 401(k), to a Roth IRA. While conversions typically involve taxes upfront, they offer the benefit of tax-free withdrawals during retirement.
However, it’s essential to consult with a tax professional or financial planner before taking any action. Drawing too much from your retirement accounts can trigger unnecessary taxes, raise Medicare or Affordable Care Act premiums, and lead to other financial consequences, including the risk of depleting your retirement savings prematurely. Avoiding these potential pitfalls necessitates careful and strategic planning.