Most people are not familiar with the impact of taxation on Social Security benefits. This can be harmful because without proper planning, taxation can reduce Social Security benefits by up to 30% in some cases! This is called the Social Security Tax Torpedo and should be avoided whenever possible.
Whether or not your Social Security is subject to taxation depends on your level of Provisional Income. Provisional income is defined as follows:
Provisional Income = Modified Adjusted Gross Income + Tax Exempt Interest + 50% of Your Social Security Benefits
The Provisional Income formula (also known as the Combined Income formula) determines how much of a retiree’s Social Security is subject to taxation. Up to the thresholds listed below, Social Security benefits are tax-free. Once the first threshold is reached, up to 50% of Social Security benefits are subject to taxation. Once the second threshold is reached, up to 85% of Social Security benefits are subject to taxation.
Listed below are the first and second thresholds limits:
If you’re only living off of your Social Security income, it will be unlikely that your benefits will be subject to tax, however, if you are not, be sure to plan carefully to structure your income sources to help minimize tax on your Social Security.
Given that a maximum of 85% of your Social Security is subject to tax, that means that at least 15% of your Social Security benefit will be tax-free, but try to minimize this tax burden where possible by working with an advisor that can assist you.
Minimize Your Non Social Security Income
Ironically, even though the Social Security Tax Torpedo hits many retirees very hard, few professionals have done much to avoid it.
To minimize taxes on your Social Security benefits received, you need to minimize income from other sources that are subject to tax so that your adjusted gross income is as low as possible.
Here are a few ideas for doing so:
- Give to Charity: Generally, you may deduct up to 50 percent of your adjusted gross income, but 20 percent and 30 percent limitations apply in some cases.
- Withdraw Money from a Tax-Free Roth IRA: Social Security income and 401(k)/IRA income are taxed differently which presents opportunities for smart tax planning. For instance, income received from a Roth IRA is not included in the Provisional Income formula which means that if a substantial portion of a retiree’s non-Social Security income comes from a Roth IRA, it is likely that the recipient’s Social Security will be subject too little or no tax.
- Buy a QLAC: Up to $125,000 from your IRA or 401K can be invested in a type of deferred-income annuity called a Qualified Longevity Annuity Contract (QLAC). Money invested in a QLAC does not count when figuring your required minimum distribution (RMD) which means the size of your RMD will be reduced and will therefore reduce your overall taxable income.
- Minimize Current Year Income from Other Investments: If you have the option of taking a capital gain in the current year for instance versus waiting a month or two to put yourself in a new tax year, consider waiting to sell in order to help you minimize your adjusted gross income this year.
How to Pay Your Social Security Taxes
If you do owe tax on your Social Security benefits, there are a couple of ways that you can pay these taxes:
- You can have them withheld from your Social Security payment each month. When you sign-up for Social Security, you can ask Social Security to withhold taxes from your benefits each month. Or, if you’re already receiving Social Security and want to change your withholding arrangement, fill out IRS form W-4V to have the Social Security Administration withhold taxes from your monthly benefits.
- The other option is to pay estimated taxes on a quarterly basis. When you file your taxes each year, you can get a refund for any over payment or you can catch-up at that time if you underestimated what should have been withheld.
The Bottom Line
Understanding how your taxes impact your Social Security is an important consideration when deciding when and how to file for your Social Security.
Whether any of the strategies above are right for you, requires careful analysis as each situation is different. If you would like to schedule a Free Initial Consultation with an advisor, you can do so by clicking here.
Until next time,
Matthew Allen is the Co-Founder/CEO of Social Security Advisors and creator of the new course Maximizing Your Social Security produced in conjunction with Weiss Educational Services. Matthew has helped thousands of seniors maximize their Social Security benefits and avoid costly mistakes when filing. Matthew has been at the forefront of financial services for over a decade. In addition to co-founding Social Security Advisors, Matthew also founded The Universal Group of Companies, a private investment firm, in 2004. From 2000 to 2004, Matthew was a NYSE Market Maker with LaBranche & Co., a Fortune 500 New York Stock Exchange firm.