Nearly 90% of individuals over age 65 rely on Social Security income to pay for a large portion of living expenses throughout their retirement years. The federal government makes this benefit available to those who have worked and contributed to the system for a certain number of years, but the total monthly benefit varies from person to person. Although Social Security is an unavoidable part of most people’ retirement planning, retirees may not be fully aware of how and when those benefits are taxed.
How can my overall tax rate change?
Half of your Social Security benefits count toward your combined income, which contains your adjusted gross income plus nontaxable interest. If your combined income reaches a specific threshold – $25,000 for an individual and $32,000 for a married couple filing jointly – you ’ll have to pay income tax on anywhere from 50% to 85% of your Social Security benefits. The Social Security website has more information on the percent of benefits taxable.
When Social Security Is Not Taxable
For retirees who receive Social Security income with little to no supplemental influx of cash, either from retirement plan distributions or other earnings, most likely those benefits are not taxable. The average benefit received is just under $1,300 each month, totaling $15, 600 annually, and benefits are only taxable when combined income exceeds $25,000 for single retirees or $32,000 for couples filing joint tax returns. Individuals who are able to sustain the type of lifestyle they need or want on that amount of income do not pay taxes on their Social Security benefits.
Keep your income below the threshold
You almost certainly won’t have to pay tax on your payments, if your only source of retirement income is Social Security. Most individuals would not have a sufficient amount of income to hit the brink and have any of their Social Security income be taxable.
However, once the sum of your adjusted gross income, nontaxable interest and half of your Social Security benefit tops $25,000 for individuals and $32,000 for couples, you may have to pay income tax on up to 50 percent of your Social Security benefit. And if these retirement income sources top people and $44, for $34,000 000 for couples, up to 85 percent of your Social Security payments may be taxable.
But no workers pay income tax on 100 percent of their Social Security retirement benefit under current law. It’s going to extend down over time to more of the middle class. Workers collectively paid $20.7 billion in taxes on their old-age and survivors insurance benefits in 2013.
Consider delaying Social Security benefits.
The last several articles we’ve published have gone over a myriad of benefits associated with delaying your Social Security. Promising Social Security as late as age 70 results in higher income later in life, higher overall income for clients who live past the breakeven age, and higher survivor benefits for widows and widowers. Now we know delaying Social Security can be smart from a tax point of view also.
Use Tax Arbitrage to Your Advantage
Up to 85% of your Social Security benefits received can be taxed, but never 100%. This means that after taxes, a dollar of Social Security income is worth more than a dollar of IRA withdrawals.
It can make a significant difference over the course of your retirement years if you design a retirement income plan that takes advantage of this tax arbitrage. You can pay less in tax, and have more to spend.
There are many ways when you begin taking money, you can aim to reduce taxes. The most common strategy is to delay the start of your Social Security benefits to age 70 while taking IRA withdrawals or using Roth conversions in your 60’s. This isn’t the best choice for everyone, but for many families, this approach results in less total taxes during their retirement years.
Much of the planning has to do with how other sources of income affect how much of your Social Security benefits will be taxable. Many can lower their tax bill by planning the timing of those other sources of income out.
Consider drawing off “tax deferred” retirement assets
Although preserving the tax deferral of IRAs is often recommended, there are instances where it makes more sense to start siphoning off cash earlier than you must. One such example is for the purpose of delaying Social Security benefits to age 70. This increases your lifetime Social Security benefits and decreases your total tax bill. The reason is that taxes on Social Security benefits raise the effective tax rate on whatever IRA distribution you take.
The easiest method to minimize combined income is to keep your expenses low after retirement. This is a major reason it’s a good idea to pay off your mortgage before you retire. A mortgage payment is the biggest monthly expense for many households. When you can eliminate that bill, then it will be quite a bit easier live on $32,500 per year.
Around this time of the year, no one likes the word “tax”. The tax code is incredibly complicated, and it’s a huge concern to cope with. However, if you plan it right, you won’t need to pay much tax at all in retirement. It is an excellent feeling in order to keep more of your money when you need it the most.