Did you know that if your income is high enough, you'll have to pay taxes on some of your Social Security benefits? In fact, you may have to pay income tax on up to 85% of your retirement benefit checks. Luckily, there are ways to reduce or even eliminate those taxes by making most of your income nontaxable.
How Social Security taxation works
Whether or not your Social Security benefits are taxed depends on your "combined income." If your adjusted gross income (which includes all taxable forms of income, including distributions from your traditional 401(k) or IRA), plus any nontaxable interest, plus one-half your annual Social Security benefits exceeds a certain threshold, then your Social Security benefits become taxable. For single filers, the minimum threshold is $25,000 in combined income per year; for joint filers, it's $32,000 per year (if you're married filing separately, the threshold is zero -- so you may wish to avoid this filing status once you start getting Social Security benefits).
The higher your combined income, the more taxes you'll likely pay on your Social Security benefits. Depending on your total income under this formula, you could end up owing taxes on up to 85% of your Social Security checks. You can find more information on whether and how much your benefits will be taxed here.
Keeping taxable income low
You're unlikely to incur taxes on your Social Security benefits unless you have a significant amount of taxable income for the year. So getting rid of those taxes requires you to keep your taxable income low enough that you won't hit those combined-income thresholds.
For most retirees, the single biggest source of taxable income is distributions from their tax-deferred retirement savings accounts -- namely, traditional IRAs and 401(k)s. You didn't have to pay taxes on the money you contributed to these accounts, but when you take the money out, you have to pay the piper (aka the IRS) in the form of income taxes on each distribution. And because the IRS is eager to start collecting its due, you'll be required to take certain minimum distributions from these accounts starting at age 70-1/2. Thus, the only long-term solution to Social Security benefit taxes is to get rid of your tax-deferred retirement savings accounts.
The Roth IRA conversion
Getting rid of your tax-deferred retirement accounts does not mean emptying the accounts in a spending spree; while that would certainly reduce your future taxes (in addition to being a whole lot of fun), it would also leave you with practically no money to live on. Instead, you can transform your retirement savings from taxable to nontaxable income by converting your tax-deferred retirement accounts into Roth accounts. This is what's known as a Roth conversion or rollover.
It's important to realize that this conversion won't spare you from paying income taxes on the money in the tax-deferred accounts: You'll have to pay those taxes in the year you make the conversion. However, in future years, when you take distributions from your newly minted Roth account, the money will not be taxable, and thus you can take as much as you want from your Roth accounts without triggering a Social Security tax bill (and since you've already paid the income taxes on that money at the time of the conversion, your total tax bill in those future years will be very low).
Managing your Roth conversion
Because any funds you convert to your Roth account will be taxed that year, converting the entire amount all at once can trigger an enormous income tax bill. If you can reasonably afford to pay such a bill, then by all means, rip off the Band-Aid and get your conversion over with all at once. However, most retirees with substantial retirement savings would be advised to spread the conversion out over several years.
For example, let's say you do the math on converting your traditional IRA to a Roth IRA and discover that it would generate a $10,000 income tax bill for the year. That's more than you're comfortable paying, but you decide that you could handle a $2,500 income tax bill without difficulties. In that case, you can open a new Roth IRA and rollover one-quarter of the money from your traditional IRA to the new account every year for the next four years. At the end of that time, all your money will be safely tucked away in the Roth IRA, you'll have paid all the taxes on the money in your Roth account, and you'll likely never have to pay Social Security benefits taxes again.