Last week I discussed several strategies for maximizing your social security benefits. This week I’ll examine some of the nuances of how your Social Security benefits are taxed and how you might be able to reduce those taxes.
To determine if your Social Security benefit is taxable then you have to calculate what is called your “combined income.” “Combined income” is defined as your adjusted gross income (commonly referred to as your AGI) plus nontaxable interest (for example, interest on muni bonds) plus half of your social security benefit. Note that only half of your social security benefit is used to calculate your “combined income.” Here are the categories:
- No taxes on Social Security. For joint filers with combined income below $32,000 ($25,000 for single filers) there is no federal taxation of Social Security benefits.
- Taxes on up to 50% of Social Security. Joint filers with combined income between $32,000 and $44,000 ($25,000 to $34,000 for single filers) may have to pay income taxes on up to 50% of their Social Security benefits.
- Taxes on up to 85% of Social Security. For joint filers with combined income above $44,000 ($34,000 for single filers) then you may pay taxes on up to 85% of your benefit. No one pays federal income tax on more than 85% of his or her Social Security benefits.
Are there strategies you can use to reduce taxes on your Social Security benefits?
Strategy #1: Draw retirement benefits; postpone Social Security benefits. Let’s say you are retired at age 62 and you have the option of taking your Social Security benefit now or deferring until age 70. This strategy involves you deferring your social security benefit until age 70 and taking your current income need from your 401k or IRA. Your Social Security benefit is increasing each year you delay. You will be required to take Required Minimum Distributions at age 70½ from your retirement accounts but typically the initial amount is only about 3%. The advantage is a much higher Social Security benefit for you (and your spouse should he/she outlives you). For example, if your age 62 benefit was $750 per month; by waiting until age 70 to claim benefits they would rise to $1,320 per month. Remember that if your spouse survives you, he/she can choose to take 100% of your benefit. The goal of this strategy is once you start taking social security to keep your combined income below the taxable social security thresholds therefore receiving social security at little or no tax. The risk of this strategy? If you (and your spouse) die before or shortly after age 70, you will have spent retirement plan assets that would have gone to heirs and you would have received little to no Social Security benefits. This strategy works best if you expect your spouse and/or you to live well into your eighties or beyond.
Strategy #2: Reduce your ‘combined income’ by paying off debt. One strategy is to reduce your income by paying off debt. Say you take savings that was producing taxable interest and pay off your home mortgage. Mortgage interest is not used in the ‘combined income’ calculation for Social Security taxes but you will have reduced your AGI. While your income has gone down, so have your expenses as well as potentially reducing taxes on your Social Security, especially if you are on the borderline of the 50% or 85% threshold discussed earlier.
Strategy #3: Convert to a Roth. Roth income or distributions are not part of the combined income calculation for Social Security income tax purposes. The year that you convert from a traditional IRA to a Roth will likely cause higher taxation on your Social Security benefits that year, but in the years that follow you may have substantially reduced taxes on your Social Security benefits. An alternative would be to do your Roth conversions over several tax years. It’s worth noting that the Roth conversion may also trigger a higher Medicare Part B premium for the year of conversion.
Your particular circumstances will dictate which of these strategies may be appropriate and I recommend that you seek the advice of your tax advisor.