Millions of seniors today rely on Social Security as a major source of retirement income. Even if you enter retirement with a sizable nest egg, you might still find that those benefits end up covering a lot of your bills.
That's why it's important to know what to expect from Social Security. You should, for example, have a sense of what your monthly benefit will look like well ahead of retirement. You should also know how much of your monthly benefit you're likely to be able to keep versus lose in the form of taxes.
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Many seniors are actually shocked to realize that Social Security income has the potential to be taxable. The good news, though, is that one key move on your part might get you out of paying those taxes.
Know how taxes on Social Security benefits work
If you're in line for a $2,000 monthly check from Social Security, you might assume that you'll get to keep all that money as a retiree. But that's not necessarily the case.
First of all, you should know that there are 12 states that tax Social Security benefits. So if you live in one of those, you might lose some money to taxes unless you qualify for an exemption. But regardless of where you live, Social Security can also be taxable at the federal level. Whether or not you'll have to pay taxes on a chunk of your benefits will depend on what your provisional income looks like.
Your provisional income is calculated by taking half of your annual Social Security benefit and adding it to your adjusted gross income plus any tax-free interest income you're privy to. So let's say you collect $2,000 a month, or $24,000 a year, from Social Security. Let's also say you withdraw $2,000 a month, or $24,000 a year, from a traditional IRA. All told, that leaves you with a provisional income of $36,000 a year.
That's not a particularly high number. But the thresholds at which federal taxes on Social Security apply are actually pretty low. You'll be subject to taxes on up to 50% of your Social Security benefits if your provisional income is:
- $25,000 to $34,000 and you're single
- $32,000 to $44,000 and you're married
Meanwhile, if you're single with a provisional income above $34,000, you could face taxes on up to 85% of your Social Security benefits. If you're married with a provisional income above $44,000, the same holds true.
A good way to avoid paying taxes on Social Security benefits
If the idea of losing some of your Social Security benefits to taxes seems terrible to you, then lowering your provisional income could be your ticket to avoiding that fate. A good way to pull that off without denying yourself the income you need is to house your savings in a Roth retirement plan instead of a traditional one.
Let's say you save for retirement in a Roth IRA. Those withdrawals aren't considered taxable income, so they don't count toward provisional income.
Going back to the example above, instead of a provisional income of $36,000, you'd be looking at just $12,000. That puts you below the threshold where taxes on benefits come into play.
If you currently have your retirement savings in a traditional retirement plan, you could always do a Roth conversion and move that money over. Doing so will mean paying taxes on that sum in the near term. But in exchange, you'll get the benefit of tax-free withdrawals from your savings in retirement, plus the potential to shield your Social Security benefits from taxes as well.
