Social Security benefits may be taxable
Many retirees are surprised to learn that they have to pay taxes on their Social Security benefits because of other income they earn while collecting those benefits.
For federal tax purposes, single filers with adjusted gross income (AGI) under $25,000 and joint filers with AGI under $32,000 pay no taxes on their Social Security benefits. That means if Social Security is your only form of income for a tax year, you likely won’t pay taxes on those benefits.
But if your income is between $25,000 and $34,000 ($32,000 to $44,000 for joint filers), then half of your benefits may be considered taxable income. Make more than those levels and up to 85 percent of your Social Security benefits are taxable. If you are married and file a separate tax return, you probably will pay taxes on your benefits.
It’s also important to know that half of your gross Social Security benefits count toward that AGI number.
So assume you collect $26,000 in Social Security benefits and you withdraw another $50,000 from an IRA or 401(k). Your AGI will be $63,000 (1/2 of $26,000 + $50,000). That means 85 percent of your Social Security benefits will be taxable in addition to the IRA income.
Your Social Security benefits may also be taxable on your state income tax returns depending on where you live.
The following states tax Social Security benefits in the same manner as the federal government: Minnesota, Nebraska, North Dakota, Rhode Island, Vermont, and West Virginia.
Another seven states tax Social Security payments, but offer exemptions based on certain factors: Colorado, Connecticut, Kansas, Missouri, Montana, New Mexico, and Utah. Those exemptions may be income amounts that are higher than the federal limits, while other states offer tax exemptions based on age.
Unfortunately, more retirees are paying taxes on Social Security benefits each year because the income limits are not adjusted for inflation.
For many retirees, the amount of income they withdraw from an annuity or tax-qualified retirement plan can push them over the income limit for Social Security taxation. For others, income they earn from wages, business earnings, or interest and dividends can create a taxable amount for Social Security benefits.
If you will earn enough money to push your AGI over the federal and/or state limits, you can have taxes withheld from your benefit checks, similar to how your taxes are withheld from a job paycheck. To do this, you can ask Social Security for IRS Form W-4V or download it from the Social Security website at www.ssa.gov. The form will give you the option of having one of the following percentages of your benefits withheld from each check: 7 percent, 10 percent, 15 percent or 25 percent. You an also make quarterly tax payments. Either option will make it easier to pay Social Security taxes rather than having to pay a lump sum when you file.
Strategies to reduce Social Security taxes
Another way to reduce or eliminate your Social Security tax bill is to reduce your adjusted gross income (AGI) so that it falls under the federal income limit. But you want to do it in a way that you still have enough money to live on during retirement. A few strategies include:
Buy a deferred annuity. You can build up retirement savings on a tax-deferred basis, which means as that money grows it will not impact your Social Security tax liability.
Convert your regular IRA or 401(k) to a Roth. Money withdrawn from Roth accounts are not taxable and do not contribute to making your Social Security benefits taxable. Keep in mind however that you may owe taxes on the amount you convert to a Roth at the time of conversion.
Sell depreciated stock or other assets. If you sell securities or other assets that are valued less than what you paid for them, you won’t owe any taxes on the proceeds. In fact, in many cases, you will receive a tax credit for the loss of value. The proceeds of the sale can therefore provide cash for expenses without increasing your AGI.
Withdraw double one year. Some planning experts say you can reduce your tax bill for a year at least if you withdraw enough income for two years at a time. Under this scenario, you would pay a higher tax bill one year, but owe no taxes the next since you would not have any reportable income the second year. For example, if you plan to withdraw $40,000 from a 401(k) each year, you would instead withdraw $80,000 one year and set aside half of it for the following year. So in that second year, you have no income that would affect your Social Security but you still have enough to live on. Be sure to consult a tax expert to ensure this is a viable solution in your circumstances.
Delay Social Security benefits. Another strategy to minimize Social Security taxes is to draw down your 401(k) and IRA balances before signing up for Social Security. This will result in higher monthly benefits because the longer you wait to claim Social Security, the more it pays out.