Smart financial planning can help retirees save thousands of dollars in taxes on their Social Security benefits, yet most aren’t aware of the strategies available to them.
At a Glance
- Social Security benefits become taxable when your “combined income” exceeds certain thresholds: $25,000 for singles and $32,000 for married couples filing jointly
- Up to 85% of your Social Security benefits could be taxed if your income exceeds the highest thresholds
- Roth IRA distributions don’t count as income for Social Security tax calculations, making them a powerful tax planning tool
- Strategic income planning, such as reducing business income or utilizing charitable donations, can help reduce your taxable Social Security benefits
Understanding When Social Security Benefits Become Taxable
Many retirees are shocked to discover their Social Security benefits can be taxed. The taxation depends on what the IRS calls your “combined income,” which includes your adjusted gross income, 50% of your Social Security benefits, and any non-taxable interest you receive. For individuals, if this combined income falls between $25,000 and $34,000, up to 50% of your benefits may be taxable. If your combined income exceeds $34,000, up to 85% of your benefits could be subject to taxation.
For married couples filing jointly, the thresholds are slightly higher. Combined income between $32,000 and $44,000 may result in taxation of up to 50% of benefits, while income above $44,000 could lead to taxation of up to 85% of benefits. These thresholds haven’t been adjusted for inflation since they were established, meaning more retirees face potential taxation each year as their retirement incomes rise with inflation.
“Therefore, the secret is to reduce your adjusted gross income in order to prevent provisional income from triggering a tax on Social Security,” says Kelly Crane, a financial advisor.
The Power of Roth IRAs in Reducing Social Security Taxes
One of the most effective strategies for minimizing taxes on Social Security benefits involves Roth IRAs. Unlike traditional IRAs and 401(k)s, qualified distributions from Roth accounts are tax-free and don’t count toward your combined income calculation for Social Security taxation purposes. This creates a significant opportunity for tax planning. If you can structure your retirement income so that a substantial portion comes from Roth accounts, you might keep your combined income below the taxation thresholds.
Here's how a tax withdrawal could look like to pay $0 in taxes for a couple looking to early retire:
1. Withdraw $29,200 from your tIRA/401(k) using either the Rule of 55 or establish substantially equal periodic payments (Section 72(t) of the IRS). Since the withdrawal equals…
— The Money Cruncher, CPA (@money_cruncher) September 30, 2024
Planning is essential when using Roth accounts to avoid Social Security taxes. For those still several years from retirement, making regular contributions to Roth accounts or considering Roth conversions (converting traditional IRA assets to Roth) can be beneficial. However, Roth conversions require careful timing since they create taxable income in the year they’re completed. Many financial advisors recommend spreading conversions over several years before retiring to minimize the annual tax impact.
Strategic Income Management Techniques
Beyond Roth accounts, several other strategies can help reduce your taxable income and potentially lower taxes on Social Security benefits. If you own a business, consider timing income and expenses strategically. “Reduce any K-1 or pass-through income from a business by increasing business deductions or expenses,” advises Kelly Crane. This approach can help keep your combined income below the taxation thresholds.
Another effective strategy involves charitable giving. If you’re required to take minimum distributions (RMDs) from traditional retirement accounts, consider making qualified charitable distributions (QCDs) directly from your IRA to charity. These distributions satisfy your RMD requirements without increasing your adjusted gross income. For investors with taxable investment accounts, tax-loss harvesting—selling investments at a loss to offset capital gains — can also help manage your combined income levels.
If you're a business owner, you can pay your children $13,850 (tax-free) and deduct it from your own taxes (legally).
By doing this, you can legally reduce your taxable income by $13,850 and avoid paying tax on that amount, plus your child will owe $0 taxes on that amount, and…
— Andrew Lokenauth | TheFinanceNewsletter.com (@FluentInFinance) November 14, 2023
Timing Your Income for Maximum Benefit
Strategic timing of retirement account withdrawals and other income sources can significantly impact your Social Security tax situation. Consider drawing down non-retirement savings first to delay taxable IRA withdrawals. If possible, take larger distributions from traditional retirement accounts before beginning Social Security benefits, then reduce these withdrawals once Social Security begins. This approach can help smooth out your income and potentially keep more of your Social Security benefits tax-free.
While state taxation often gets less attention, it’s equally important to consider in your planning. Twelve states currently tax Social Security benefits to some degree, while 38 states exempt these benefits from taxation. If you’re considering relocation in retirement, this factor could influence your decision. The tax impact could be substantial depending on your income level and state of residence. “Tax strategy should be part of your overall financial planning,” emphasizes Kelly Crane.
While many retirees focus extensively on minimizing taxes, it’s crucial to maintain perspective. About 60% of Social Security recipients already pay no federal taxes on their benefits, primarily because their total income falls below the taxation thresholds. Having higher income in retirement, even if it results in some taxation of benefits, is generally preferable to having insufficient income. The goal should be creating a tax-efficient retirement plan that balances income needs with tax considerations to maximize your financial security throughout retirement.
