Throughout your working life, you pay taxes to earn Social Security benefits. That's why it comes as such a surprise to many retirees that taxes don't stop once you start collecting checks.
In fact, a report from Senior Citizens League found around half of all Social Security beneficiaries owe federal taxes on their money. And it's not just the IRS you have to worry about, either. A total of 13 states currently tax at least some seniors on their benefits.
The good news is, you don't have to just accept that you'll lose part of your hard-earned retirement benefits to the tax man. There are a few options to avoid this, especially if you start working on them early.
Who has to pay taxes on Social Security benefits?
You will be taxed on Social Security benefits only if your income exceeds a specific threshold. The income that matters here is provisional income, which equals:
- Half your Social Security benefit.
- All taxable income.
- Some nontaxable income, such as muni bond interest.
If your provisional income is between $25,000 and $34,000 as a single tax filer or between $32,000 and $44,000 as a married joint filer, you could be taxed on up to 50% of benefits. And if your provisional income exceeds $34,000 as a single filer or $44,000 as a couple filing jointly, then you could be taxed on up to 85% of your benefits.
These thresholds stay the same year over year, as they aren't indexed to inflation. That means a growing number of retirees will owe taxes, since incomes tend to go up over time.
Different states also set different rules for when benefits are taxed, which aren't always perfectly aligned to the federal rules.
How can you reduce your tax bill?
Your options for reducing your tax bill will depend on your situation. But there are two main steps you can take.
1. Be smart about where you live
If you live in one of the states that taxes your Social Security income, the easiest way to save on your tax bill is simply to move to a different location in retirement.
You have plenty of options for places to live where your local government won't take a portion of your hard-earned benefits.
2. Choose the right investment accounts
Avoiding federal taxes is harder, but it can be done by limiting your withdrawals from taxable retirement accounts to keep your provisional income below the threshold at which benefits become taxable.
That's difficult, though, because it could mean reducing your quality of life if you're used to a higher income. And, depending on how much you have invested, required minimum distributions that start at 72 could make this impossible without causing you to incur tax penalties for withdrawing too little.
The good news is, you may have another option. If you're still young, you can use a Roth 401(k) or Roth IRA to invest for retirement instead of using a traditional account. if your money is in a Roth, withdrawals won't count as part of the income that is used to determine if your Social Security benefits are taxed.
Of course, you'd either need to invest in a Roth throughout your career or deal with the consequences of rolling over a traditional account to a Roth if you want to take this approach.
These consequences can be substantial if you are nearing or already in retirement. Not only could you face a large tax bill after a rollover, but you could also limit access to your retirement funds for a period of time. It's a good idea to consult with a tax professional to see if the math makes sense on that move before you try to do a rollover to reduce your Social Security tax bill.