Did you know that your Social Security benefits may be subject to income taxes? If you don't factor these taxes into your retirement budget -- or find a way to avoid them altogether -- you could end up with significantly less income than you expect. Fortunately, getting around the Social Security benefits tax is fairly easy, if you prepare for it in advance.
The Social Security tax threshold
Whether or not your Social Security benefits are taxable depends on how much income you receive from different sources during the year. The formula for determining your Social Security taxability looks at your taxable income from other sources, plus nontaxable interest, plus one-half the Social Security benefits you receive during the year. The combination of these three types of income is what the Social Security Administration unimaginatively refers to as "combined income."
If your combined income is over $25,000 (for individual tax-return filers) or $32,000 (for married couples filing jointly), your Social Security benefits will be partially taxable. Up to 85% of your benefits may be taxable if your combined income far exceeds the threshold.
You can spare your Social Security benefits from taxation by keeping your combined income below the taxation threshold. But how do you do that without giving up income? The trick is to convert some, or all, of your taxable income to nontaxable income so that it's not factored into your combined income.
Making your income nontaxable
For most retirees, the biggest source of taxable income is a retirement savings account, often a traditional IRA or 401(k). The easiest way to convert such income to a nontaxable form is to move it into a Roth account. Roth IRAs are essentially the opposite of traditional IRAs: You don't get a tax break on your contributions, but the money you take out of the account is tax-free. That makes them perfect for retirees looking to reduce their income taxes.
If your retirement date is still a decade or more away, then now is a great time to open up a Roth IRA and start contributing to it. Usually the best arrangement is to split your contributions between a traditional IRA or 401(k) and a Roth account. That way, you still get a tax break immediately, yet you're also giving yourself some tax-free income in the future. Workers who are fairly close to retirement and are only just opening a Roth IRA will probably want to maximize their Roth contributions to ensure they have a fairly high balance in the account by the time they retire.
On the other hand, if your income is much higher now than you expect it to be after you retire, your best bet is to maximize your contributions to a traditional IRA or 401(k), as that will result in a higher overall tax break. After you retire, you can still move those funds to a Roth account so that they'll produce nontaxable income -- more on that below.
What if I'm already retired?
A retiree or someone close to retirement can still benefit from a Roth account's tax-free income by performing a Roth conversion. That simply means taking money from your traditional IRA or 401(k) and dumping it into a Roth account. A Roth conversion is a good move if all, or nearly all, of your retirement savings are in a traditional IRA or 401(k), as it would be difficult or impossible to avoid taxes on your Social Security benefits in that scenario. The only problem with a Roth conversion is that you have to pay taxes on the amount you convert, in the year you convert it. That can end up being quite expensive if you have a lot of money to move over. For example, converting $300,000 from your traditional IRA to a Roth IRA all at once would add $82,070.25 to your tax bill for the year (using the 2018 tax brackets for single filers) -- or potentially even more, if you have enough income from other sources to bump you to the top tax bracket.
Instead, it's best to spread a large conversion out over several years to minimize the tax impact, preferably starting a few years before you retire. If you spread your $300,000 conversion out over 10 years, for example, it would cost you just $7,500 per year in extra taxes (assuming you're in the 25% tax bracket after adding the converted funds to your income). If you're already retired at that point, you'll end up paying taxes on your Social Security benefits during those years (which is another reason why it's best to start converting before you retire), but once the conversion is complete, you'll have gotten rid of those taxes for good.
Using your Roth to get rid of Social Security taxes
Let's look at exactly how a well-funded Roth account can eliminate your Social Security benefits taxes. For the purposes of this example, we'll say that your Social Security benefit is $1,500 per month and you need a total of $40,000 per year in income, consisting of your Social Security benefit plus withdrawals from your retirement savings accounts.
If you're a single filer, you need to keep your combined income under $25,000 to keep your Social Security benefits completely tax-free. Combined income includes one-half your Social Security benefits for the year, which in this case would be $9,000. Assuming you don't have any nontaxable interest, that means you need to keep your taxable income from other sources under $16,000 for the year. If you have retirement savings in both a traditional IRA and a Roth IRA, this is easy enough to accomplish: All you need to do is take $15,000 from your traditional IRA for the year, then take the remaining $7,000 that you need in annual income from your Roth IRA.
Not only will you not owe taxes on your Social Security benefits, but by keeping your taxable income to $15,000 for the year, you may not have to pay income taxes at all. Once you subtract your standard deduction and personal exemption from your $15,000 of taxable income (using the 2018 figures), you'll have just $4,350 left to pay taxes on – or even less if you're 65 or older and can therefore take the senior standard deduction. If you can come up with a few extra deductions and credits, you may be able to wipe out your income tax bill entirely; if not, at most you'll owe just $435 in taxes on your income. That's a financial boon that more than compensates for postponing part of your IRA tax break.