One of the Social Security details that's often overlooked is that benefits are indeed taxable.
In 1983, Congress implemented amendments to the Social Security program that allowed the Internal Revenue Service to collect tax on unmarried Social Security recipients earning more than $25,000 annually, as well as married beneficiaries with a combined income in excess of $32,000 annually. This amendment subjected 50% of recipients' benefits that crossed these income thresholds to federal taxation, and it was ultimately expected to affect just 1 in 10 beneficiaries.
In 1993, another amendment was made to the program under the Clinton administration that allowed the IRS to collect tax on up to 85% of recipients' benefits. Under the 1993 amendments, unmarried persons making between $25,000 and $34,000 annually were subject to having 50% of their Social Security benefits taxed, while earning income above this amount could expose 85% of their benefits to taxation. For couples, 50% of Social Security benefits became taxable between $32,000 and $44,000, with any amount above and beyond $44,000 leading to 85% being subject to taxation.
The big issue with this 33-year-old Social Security tax is that the income thresholds haven't been adjusted for inflation. What was once a tax that was estimated to affect just 10% of all Social Security recipients now affects more than half of all retired workers according to The Senior Citizens League.
Strategies that could lower your Social Security tax bill
Paying tax on your Social Security benefits probably isn't what you bargained for in retirement, so here are a few ways you could consider reducing or eliminating your Social Security tax liability.
1. Contribute to a Roth IRA or Roth 401(k)
The smartest move you can make during your working years is to contribute to a Roth IRA or Roth 401(k).
Workers have a bounty of investment vehicles available when saving for retirement, but the Roth IRA and Roth 401(k) have one very special advantage. Namely, eligible withdrawals made from Roth accounts during retirement don't count toward your annual income since the money contributed is after-tax dollars. Regardless of how much is withdrawn on an annual basis, neither a Roth IRA nor Roth 401(k) will count toward your income. This should give retirees a decent shot at staying below the income thresholds where Social Security taxes kick in.
Other types of investments, such as 401(k)s, Traditional IRAs, and even tax-free municipal bond interest, do count toward your income for the purpose of determining whether or not you'll owe tax on your Social Security benefits.
2. Hold off on claiming benefits
A potentially smart move you can make during retirement to reduce your Social Security tax liability is to consider holding off on filing for benefits.
According to the Center for Retirement Research at Boston College, about 45% of all retirees file for benefits as soon as possible at age 62 based on data from 2013. Overall, approximately 3 in 5 claim benefits before hitting their full retirement age, or FRA, which is a dynamic number based on your birth year that determines when you're eligible to receive 100% of your benefits. The implication of this data is that most seniors are receiving less than 100% of their FRA. But there's a bigger implication here.
If seniors plan to work while also receiving Social Security benefits, they could be setting themselves up to move into a higher tax bracket, potentially exposing themselves to Social Security taxes. Furthermore, seniors may not realize that the Social Security Administration sets income thresholds on how much a beneficiary can earn before reaching their FRA. If a worker reaches this threshold, some, or all, of their benefits could be withheld. Waiting to file until after your FRA will not only boost your benefit by an average of 8% per year, but it'll save you from the hassles of having your benefits withheld, and from possibly being taxed while working.
3. Move to a state that doesn't tax your benefits
Another oft-overlooked fact is that 13 states also tax Social Security benefits to some varied extent. This would obviously mean that if you chose to retire in one of the 37 states that don't tax Social Security, you'll be protected (at the state level) from owing tax on your Social Security benefits.
However, not all states that tax Social Security are necessarily worth avoiding. They should be studied on a case-by-case basis.
For example, Missouri is one the 13 states that taxes Social Security benefits, but it exempts unmarried persons earning up to $85,000 in adjusted gross income (AGI) and $100,000 in AGI for married couples. This exemption is probably going to cover most Social Security recipients during retirement.
On the other hand, four states -- Minnesota, North Dakota, Vermont, and West Virginia -- offer no exemptions to retirees, meaning they follow the federal government's tax schedule for Social Security. If you retire in these four states, you could wind up owing extra taxes on your Social Security benefits.
4. Give to charity
An interesting way to reduce your chances of paying tax on your Social Security benefits is to consider donating a good chunk of your required minimum distribution from a tax-deferred plan, such as a Traditional IRA, to an eligible charity.
Because contributions to a Traditional IRA come from pre-tax dollars, it helps reduce a worker's upfront tax liability but requires a worker to pay tax on withdrawals during retirement. Once an individual with a Traditional IRA reaches age 70-1/2, required minimum distributions (RMD) kick in. An RMD is nothing more than a minimum amount that must be withdrawn annual from a tax-deferred plan. Seniors can divert up to $100,000 to an eligible charity of their choosing from a Traditional IRA without having it count toward their AGI -- which can help keep their AGI down and reduce their chances of paying taxes on their Social Security benefits -- while having the charitable contribution count toward their annual RMD.
Keep in mind that if you're a high-earning individual or couple, your focus should probably be on overall tax deductions and not just Social Security tax avoidance. However, for middle-income workers or retirees, implementing a few of these strategies could be a great start to lowering or eliminating your Social Security tax bill.