Reflections

Will I Pay Tax on Social Security?

As a retiree, you’re trying to make the most of the money you’ve saved during your working years. Maximizing your Social Security – and paying less tax on it – is a great way to make the money last.

Up to 85% of your Social Security benefit might be subject to taxation. Understand the rules and you may find yourself with an opportunity to employ simple planning strategies to lessen the tax bite. First, a brief history.

Social Security hasn’t always been taxed. But in 1983, with the Social Security Trust Fund whittling down to unsustainable levels, Congress passed the first laws to tax Social Security benefits. In 1993, when the latest tax increase for Social Security benefits was issued, 18.2% of beneficiaries saw an increase in taxes. As incomes have risen, today nearly 50% of retirees – about 15 million Americans – pay tax on their Social Security benefit.

How Is My Social Security Benefit Taxed?

The first step to determine how your social security benefit will be taxed is to know your “provisional income.”  Provisional income is your modified adjusted gross income (pensions, wages, interest, and any tax-exempt interest, such as mortgage interest or other deductions) + one-half of your social security benefits.  If your provisional income is above $44K (filing as a married couple), then 85% of your social security benefits will be taxed.  Taxation varies based on filing status and provisional income, which is shown in the table below.

If your provisional income is more than $32,000 as a married couple, or $25,000 as an individual, you’ll pay some tax on your benefit. Up to 50% of benefits are taxed for those with provisional incomes of $32,000 to $44,000 for married filing jointly couples and $25,000 to $34,000 for single filers. For those with a provisional income more than $44,000 for couples and $34,000 for individuals, up to 85% of Social Security benefits are taxed.

Consider how the social security benefit tax affect a higher-income retiree. Let’s say you and your spouse bring in $80,000 in provisional income a year, which includes half of your $25,000 of Social Security benefit. The maximum 85% of your benefit ($21,250) will be taxed. At a tax rate of 25%, this tax burden will cost you over $5,300.

Strategies for Reducing Social Security Taxation

The only available way to lessen the tax hit is by lowering your provisional income. This is not always easy. However, managing the timing and annual level of income can be an achievable way to help you reduce your overall Social Security taxation.

Draw down your 401(k) and IRAs before claiming social security.

Any money you take from your pre-tax accounts (IRAs or 401(k) rollovers) during retirement will be counted toward your provisional income. Lowering your IRA balance will reduce your Required Minimum Distribution (RMD), the amount you’ll be required to take annually beginning at age 70½ and thus lower your provisional income. Having available funds outside of IRAs (such as Roth IRAs or taxable brokerage accounts) can make it easier to manage taxable income in retirement.

Know which accounts count against you, and which can be used freely.

Income drawn from a Roth IRA does not factor into the calculation. For taxable accounts (non-IRAs or 401(k) s, only the capital gains portion of any withdrawal will count as income. Planning with Roth conversions or directing more savings into taxable accounts in your working years can lead to a better balance between taxable and pre-tax accounts when you need the funds in retirement.

Watch your income thresholds closely.

If you’re approaching the 50% or 85% thresholds, ($32K-$44 for joint filers) it makes sense to monitor your income and avoid a little bit of extra income where possible. Try to avoid spikes in income such as stock sales; or mine your taxable account for losses at the end of the year to stay beneath the thresholds.

Time your withdrawals.

Time your withdrawals around years you know you will be above the thresholds. If you know you’ll be over the 85% threshold one year, consider moving additional funds out of your IRA or taking profits on stocks during that year. You might receive more in after-tax Social Security benefits the following years when fewer factors are forcing you to take additional income.

Windgate does not provide tax advice. Consult your professional tax advisor for questions concerning your personal tax or financial situation.

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