Sadly enough, navigating the Social Security world is not always an easy path. With so many working parts and constantly changing information, it's easy to become overwhelmed.
One aspect people don't always understand is the way Social Security benefits are taxed. Unfortunately, not knowing won't excuse your tax bill, but being aware can help you strategically approach it. Below, you'll find three ways you can potentially reduce your Social Security tax burden. First, though, let's look at how taxes on Social Security benefits work.
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How Social Security taxes work
Will you pay taxes on your Social Security benefits? It depends on your provisional income, which is your adjusted gross income (AGI) plus nontaxable interest and half of your annual Social Security benefits.
Your AGI is your total annual earnings, including dividends and capital gains, minus deductions like mortgage interest or traditional IRA contributions. Nontaxable interest is interest not subject to federal income taxes, like Treasury or municipal bonds.
Here's how much of your Social Security benefits will be taxable, based on your provisional income:
| Percentage of Taxable Benefits | Filing Single | Married, Filing Jointly |
|---|---|---|
|
0% |
Less than $25,000 |
Less than $32,000 |
|
Up to 50% |
$25,000 to $34,000 |
$32,000 to $44,000 |
|
Up to 85% |
More than $34,000 |
More than $44,000 |
Data source: Social Security Administration. Chart by Author.
At first thought, it's easy to see this and think it's absurd that the IRS would take up to 85% of your benefit. It's important to remember, however, that this isn't the tax rate, just how much of your benefits are eligible to be taxed.
Someone married and filing jointly with a provisional income of $60,000 would never pay 85% of that in taxes. Rather, as much as 85% of the $60,000, or $51,000, could potentially get added to the couple's taxable income. The couple would then apply whatever tax rate they pay on income to find out how much in extra tax they'd have to pay.
1. Use a Roth account
While accounts like 401(k)s and traditional IRAs let you contribute pre-tax money, Roth accounts -- both 401(k) and IRA -- work the opposite way. Contributions are made with after-tax money, and then you can take tax-free withdrawals in retirement, as long as the other criteria, like age, are met.
Since withdrawals from a Roth account are tax-free in retirement, you can receive income that won't be included in your provisional income. Starting to contribute to a Roth account and invest early enough can put you in a position to have a nice nest egg in your Roth account(s) in retirement.
If you don't currently have a Roth account, you could consider converting funds from your 401(k) or traditional IRA. Conversions will spark a tax bill when you do it, but withdrawals will be tax-free in retirement. This could make sense for people who anticipate being in a higher tax bracket in retirement or want to reduce their future required minimum distributions (RMDs).
2. Tap into your accounts before the required minimum distributions kick in
RMDs are the annual amount you're required to withdraw from retirement accounts like 401(k)s and traditional IRAs once you turn a certain age (currently 73 years old). The amount of your RMD is determined by a formula that considers your age and the balance of your retirement accounts at the end of the previous year.
In some cases, you'll be able to take withdrawals when you're in a relatively low tax bracket. By tapping into your accounts in those cases before your RMDs kick in, you can reduce your future RMDs, lowering your Social Security tax burden down the line.
3. Donate your required minimum distributions to charity
If you hit the age when your RMDs kick in, you can avoid having your withdrawals counted as taxable income by donating the money to a qualified charity. This is known as a qualified charitable distribution (QCD).
Retirees interested in making QCDs should contact their retirement plan provider. You can't receive the RMDs and then donate the money yourself. Your plan provider must set it up to have the withdrawals sent directly to the charity.
Although RMDs kick in at age 73, you can begin making QCDs at age 70 1/2, up to $100,000 per year.
As an example, imagine someone's RMD for the year was $10,000. If they had $7,000 in QCDs, they'd only be required to withdraw an additional $3,000 during the year. Fewer RMDs means less taxable income.
