With millions of Americans relying on Social Security as a significant source of income in their golden years, it’s essential to understand how taxation can impact these benefits. A significant number, roughly 50 percent of households that received Social Security benefits in 2021 were required to pay taxes on those benefits.
However, there are ways to reduce or even eliminate the tax burden on your Social Security benefits. And the good news is that there are effective strategies to help reduce this tax burden and preserve more of your income.
Key Takeaways
Understand how taxation impacts Social Security benefits and use effective strategies to reduce or eliminate tax burden.
- Calculate combined income to determine if Social Security benefits will be taxed.
- Contribute to IRAs, utilize Roth IRAs or 401(k)s for tax-free income in retirement, and delay Social Security benefits to maximize payments and reduce taxable years.
- Manage retirement account withdrawals to minimize AGI and taxable Social Security benefits, and donate RMDs to charity if they’re not needed for living expenses.
6 Effective Strategies to Reduce Tax Burden
Calculating combined income
In order to decide whether your Social Security benefits will be taxed, you must add up all of the money you earn from various sources. The total considered consists of your AGI, interest that is not taxable, and 50 percent of your Social Security payments.
For joint filers, combine your and your spouse’s Adjusted Gross Income (AGI) along with non-taxable interest, then add half of your spouse’s Social Security benefits.
These thresholds increase to $32,000 and $44,000, respectively. Understanding this calculation is essential, as it forms the basis for the strategies that can help reduce tax liability on your benefits.
For individuals who are single or have no one financially dependent on them, it’s just a matter of adding 50% of their Social Security benefits to both their adjusted gross income and tax-exempt interest income.
For example, if your combined income exceeds $25,000, up to 50% of your Social Security benefits may be taxable. If it exceeds $34,000, as much as 85% of your benefits could be taxed.
Reducing Tax Liability through IRA Contributions
One way to potentially lower your taxable income is by contributing to a traditional Individual Retirement Account (IRA). By putting money into an IRA, you may decrease the amount of income that’s subject to taxation.
The amount you can deduct from your taxes for retirement contributions depends on how much you earn, whether you’re single or married, and if your employer offers a plan like a 401(k).
The 2024 IRA contribution limit has increased to $7,000, with those over 50 able to contribute an additional $1,000 for a total of up to $8,000. Not only does contributing to an IRA provide tax-deferred growth, but it also lowers your AGI, which can help keep your combined income below the Social Security tax threshold.
Utilizing Roth IRAs and Roth 401(k)s
These offer a unique tax advantage for retirees because withdrawals from these accounts are tax-free once certain conditions are met: being at least 59 and a half years old and having held the account for at least five years.
Unlike traditional retirement accounts, investments in these do not come with upfront tax savings, meaning they won’t increase your combined income or your Social Security tax liability. This makes them an excellent option for reducing your AGI and minimizing tax liability on your Social Security benefits.
Delaying Social Security Benefits
Choosing to delay Social Security benefits until your full retirement age (FRA) or later can provide a dual benefit: maximizing your monthly payment and reducing the years in which you receive taxable benefits.
If an individual chooses to collect Social Security benefits earlier than their full retirement age, they will receive a smaller monthly stipend. However, delaying benefits until FRA or beyond can increase your monthly payment.
Your benefit amount increases each year you delay claiming until age 70.
Optimizing Retirement Account Savings
How you draw down your retirement accounts can significantly impact your Social Security tax liability. Minimizing taxes due on your Social Security income requires strategic management of your retirement account balances and the sequence in which you access those funds as a source of income.
This may involve withdrawing from Roth accounts before traditional retirement accounts to reduce taxable income. To get the most out of your retirement savings, have your financial consultant manage them in a way that minimizes taxes through techniques including tax-loss offsetting strategies.
For those subject to Required Minimum Distributions (RMDs) from traditional IRAs or 401(k)s, consider withdrawing only what you need to minimize tax exposure.
If you don’t need your full RMD for living expenses, donating it directly to a charity (known as a Qualified Charitable Distribution, or QCD) can satisfy the RMD requirement without increasing your taxable income.
Donating Required Minimum Distributions
Once you reach age 73 (the new starting age for RMDs), you’re required to withdraw a minimum amount annually from traditional retirement accounts. If you don’t need this income, donating it directly to a qualified charity through a QCD is a great way to reduce your AGI.
If you don’t need your RMDs for living expenses, donating them to charity can be a smart move. This approach helps lower your AGI and reduces the tax burden.
These donations, up to $100,000 per year, can be excluded from your taxable income, helping reduce the combined income calculation and therefore your tax liability on Social Security benefits.
By using these five strategies, you may be able to lower taxes on your Social Security benefits. It’s also important to work with a financial advisor to find the best approach for your unique situation.
Key Reminders to Lowering Taxes
Taxation on Social Security benefits can be a financial hurdle, but with careful planning, you can minimize or avoid this tax burden. Here’s a recap:
Calculate your combined income to determine if your benefits will be taxed, contribute to an IRA to reduce your AGI, use Roth IRAs or Roth 401(k)s for tax-free income in retirement, and delay Social Security benefits to maximize payments and reduce taxable years.
Additionally, you also need to manage retirement account withdrawals to minimize AGI and taxable Social Security benefits, and donate RMDs to charity if they’re not needed for living expenses.
By taking proactive steps, you can protect your Social Security benefits from excessive taxation.
Frequently Asked Questions
Q1: Are there any circumstances in which one can start collecting Social Security benefits while still under full retirement age?
A: Yes, Social Security benefits can be taxed regardless of when you claim them. However, if you claim early, the monthly benefit amount will be permanently reduced. Taxes are based on your combined income, so it’s the total income, not the age at which you claim, that determines tax liability.
Q2: How does taxation impact my Social Security benefits?
If your combined income is high enough, up to 85% of your Social Security benefits can be taxable, although this doesn’t mean they’re taxed at an 85% rate. The taxable portion simply means that the amount is subject to your regular income tax rate.
Final Thoughts
Social Security benefits are a critical income source for millions of retirees, but understanding the potential tax implications is vital. By taking strategic steps—like contributing to IRAs, delaying benefits, or donating RMDs to charity—you can reduce taxes on your benefits, allowing you to keep more of your retirement income.
Consult a financial advisor who can personalize these strategies based on your financial situation. The effort spent planning can make a significant difference in your retirement finances, ensuring you get the most from your hard-earned benefits.
