How much of your Social Security income is taxable?
Social Security benefits are subject to federal income tax for about 40% of Americans, according to the Social Security Administration.
This usually happens because the retiree has other substantial income, such as wages, self-employment, interest, dividends, or other taxable income. When this additional income combines with the Social Security benefits, a retiree’s income level will generally exceed a certain threshold, causing taxation to kick in. (That threshold may differ from person to person, depending on their filing status and the amount of their benefits.)
To put it more simply, many benefit recipients will owe some tax on their Social Security.
There is some good news, though — only a portion of your benefits will be subject to tax, regardless of the amount you receive.
For most people, only up to 50% of their benefits are taxable. However, up to 85% of your benefits can be taxable if either of the following situations applies:
- One-half of the benefits and all other income is more than $34,000 ($44,000 for Married Filing Jointly).
- You are filing Married, Filing Separately, and lived with your spouse at any time during the year.
In either of those cases, the taxable percentage of your Social Security benefits will increase to 85%. Fortunately, it will never go any higher. No retiree ever has to pay taxes on 100% of their benefits, making Social Security tax-efficient compared to other retirement plans with fully-taxable distributions.
On the other hand, you may also need to pay state taxes if you live in one of the thirteen states which also tax Social Security benefits.
If you are unsure what part of your income is taxable, you may wish to consult IRS Notice 703, which includes a worksheet designed to help you determine if your benefits are taxable. Furthermore, the IRS’s Interactive Tax Assistant (ITA) is a valuable tool that may provide more information, including what part of your income is taxable and what possible complications may arise in your circumstances.
Who must pay Social Security tax?
Most people who work as employees in the United States must pay Social Security and Medicare taxes. These payments contribute towards their coverage under the system. They are usually deducted by their employer from each wage payment, regardless of whether or not the employee expects to qualify for Social Security benefits. (Those for whom taxes are withheld in error may seek a refund from the employer or the IRS.)
Those with the legal right to receive the benefits are included in that person’s taxable income (if taxable).
For example, if you receive Social Security benefits as a surviving spouse caring for two dependent children, the two children may also receive benefits as dependents of their deceased father; the benefits are payable to you. However, when calculating the benefits’ taxable portion (if any), you must only use the amount paid for your use.
At what age is Social Security no longer taxed?
Since the IRS determines the taxation of Social Security benefits by combined income levels and filing statuses, age is not a factor. That means there is, unfortunately, no age at which you can avoid taxation if it applies to your circumstances.
However, once you reach full retirement age, the IRS can no longer withhold your benefits if they exceed the abovementioned threshold combined with your other forms of income.
Full retirement age varies based on when you were born. The age for full retirement benefits is 66 if you were born between 1943 and 1954. It increases gradually to 67 from 1955 to 1960, after which it remains 67 for anyone born after 1960.
In 2022, you are eligible for full Social Security benefits if born before September 2nd, 1956.
How can you minimize taxes on your Social Security?
Although there is no way to avoid partial taxation on your benefits if your combined income exceeds the threshold, there are some strategies you may be able to use to reduce taxes on your Social Security.
For example, you may reduce your taxable benefits by reallocating investments that generate income, which pushes you over the threshold. For example:
- Suppose you are earning taxable interest income from a bank CD (certificate of deposit) that is causing taxation on a portion of your benefits. In that case, you could switch the investment to U.S. savings bonds, which would not generate includable income. (One caveat: Some annual purchase limits apply to this approach.)
- Similarly to U.S. savings bonds, earnings on a nonqualified annuity are deferred until you cash in the investment. Furthermore, there is also no annual limit on the amount of principal that you can invest.
- Finally, by switching investments from mutual funds stocks that produce dividend income to investments that produce capital gains (like real estate, gold, or other investments), you may realize tax savings by reducing the amount of Social Security benefits subject to tax.
You may also consider taking distributions from your 401(k) or Traditional IRA in your sixties (they become penalty-free after age 59 ½ or even 55 in some cases) before signing up for Social Security to reduce your Social Security income tax bill. Likewise, saving in a Roth 401(k) or Roth IRA can also be helpful, as distributions from such accounts are not taxable after the accounts are five years old, meaning they don’t contribute to your Social Security taxes.
If you live in one of the thirteen states that also tax Social Security, check to see if your state has exceptions for low-income retirees. (Those states are: Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont, and West Virginia.)
The bottom line
The financial side of retirement can be frustrating. You’ll pay a hefty tax if you take your benefits early. On the other hand, if you wait until you reach full retirement age, your benefits will increase, but you will have to make do until then. And if you want to minimize your eventual tax burden when you start receiving your benefits, you also need to be conscious of whether or not your income will cross the threshold.
It can be enough to make your head spin! Fortunately, you are not powerless or alone.
With the right, strategic approach, you can understand the tax implications of your Social Security benefits and make the most of your income circumstances.
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