Medicare Planning: What You Need to Know to Manage Costs and Avoid Late Filing Penalties presented by Pat Burris, CFP®. The webinar will be held on February 22nd from 3:00 PM – 4:00 PM Central Time. There is no cost to attend, but you must register in advance.
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In 2020, about 50 percent of Social Security recipients owed income taxes on their benefit payments. These taxes on benefits reduce monthly net income for retirees and cause them to spend more of their savings to make up the difference. However, those who are aware of tax laws and how they impact their Social Security payments can work to minimize taxation and maximize the spending power of their nest egg.
History of Social Security Taxation
The 1979 Advisory Council on Social Security determined that Social Security benefits should be treated more like pension payments than social services for tax purposes. Beginning in 1984, individuals with significant income above and beyond Social Security benefits became subject to tax on half of their Social Security benefits.
Later in 1993, a second income tier was introduced that increased the percentage of benefits that could be taxable. After the 1993 update, those Social Security recipients with income above the new thresholds began paying tax on 85% of their benefit amounts. Unfortunately, these thresholds were not indexed for inflation or wage growth and have not increased since their implementation. Since that time, the number of Americans who owe tax on their Social Security payments has been steadily increasing.
How to Calculate Federal Taxation on Social Security Benefits
The income thresholds for taxation of Social Security benefits are derived using a special calculation unique to this purpose, called Provisional Income or Combined Income. Combined Income includes some income which is normally non-taxable.
Calculating Combined Income
To calculate your combined income, start with your Adjusted Gross Income and add back any non-taxable interest payments that you received. Then add ½ of your annual Social Security payments. So, the resulting formula looks like this:
Combined Income = Adjusted Gross Income + Non-taxable interest + ½ Annual Social Security Benefit
For complete details on calculating your combined income, read our article on this topic: How to Calculate Provisional Income (a.k.a. Combined Income).
Calculating Your Federal Social Security Taxes Using Combined Income
Individual filers with Combined Income under $25,000 will not owe tax on their Social Security payments. Those with Combined Income between $25,000 and $34,000 pay income tax on 50% of their benefits. Individuals with Combined Income over $34,000 owe income tax on 85% of their benefits.
For married couples that file joint tax returns, those with Combined Income under $32,000 do not owe taxes on their Social Security benefits. However, those couples with Combined Income between $32,000 and $44,000 owe income tax on 50% of their Social Security payments, and those with Combined Income over $44,000 pay income tax on 85% of their benefits. Married couples that file separate tax returns but have lived together during any time in the tax year will likely owe tax on their benefits because no income thresholds apply.
If you do have to pay taxes on your benefits, you have options for how to pay. You can either pay quarterly estimated tax through the IRS or have Social Security withhold federal taxes from your benefit payment.
State Income Tax on Social Security Benefits
State income tax laws on Social Security benefits vary from state to state. Currently, 13 states tax Social Security benefits.
If you live in Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont or West Virginia, you may owe state income tax on your Social Security Benefits. So, it’s very important to pay close attention to your state income tax laws as you approach retirement.
Strategies to Minimize Tax on Social Security Benefits
Income tax laws are complex, but in some cases, this complexity creates opportunity. For example, different types of retirement accounts impact your taxable income differently. Therefore, an effective strategy to minimize taxation is crucial for high-income retirees. The easiest way to gain confidence that your retirement plan is minimizing your taxable income is speaking to an experienced financial professional, and these are some of the tactics they may employ.
Utilize a Roth IRA or Roth 401k
Roth IRAs and Roth 401(k)s are funded with after-tax dollars. This means distributions from Roth accounts are not counted as income for tax purposes when you withdraw and are not included in the calculation for Combined Income. If you are receiving Social Security payments and are close to a threshold where you will pay increased taxes on your benefits, consider taking distributions from a Roth account instead of a pre-tax account like a traditional 401k.
If you are planning for retirement, consider whether opening a Roth IRA or converting some of your pre-tax assets to Roth can offer you more flexibility during retirement. Again, discussing your retirement saving and distribution strategies with an experienced financial advisor can help you make informed decisions.
Avoid Large Distributions or Conversions from Pre-Tax Accounts
Distributions from traditional IRAs, 401ks, and other tax-deferred retirement vehicles are considered part of your taxable income. Taking a large distribution from a pre-tax account could cause you to surpass the threshold of owing tax or owing a higher amount of tax on your Social Security benefits. So, consider taking smaller distributions in multiple tax years when possible.
Funds converted from a traditional retirement account to a Roth account are also considered taxable income. One way to combat a major tax bill is converting smaller amounts each year if you are close to one of the income thresholds for Combined Income.
Delay Social Security Benefits Until You Retire
Those who choose to receive Social Security benefits while they are still working will likely pay tax on their benefits. Even a small amount of employment income can cause you to exceed the income thresholds and owe taxes on your Social Security payments.
Savvy retirement planners know it’s important to consider the tax consequences before choosing when to start taking Social Security benefits. If you can, delay those benefits until you have less income. If you’re not sure when to start taking benefits, speak to a financial professional at Meld Financial.
Prepare for a Comfortable Retirement with Financial Fingerprint™
Whether you are currently retired or planning for your retirement, working with an experienced team of financial professionals can help you achieve your goals. At Meld Financial, our team of financial, legal, and tax professionals work together to develop a financial plan designed to meet your needs and minimize your tax burden.
In a single meeting, our team will develop your Financial Fingerprint™, a comprehensive wealth management plan that is quick to assemble, easy to understand, and simple to modify as your circumstances change. We developed the Financial Fingerprint™ process here at Meld Financial during over 30 years of managing our clients’ wealth. With your Financial Fingerprint™, you can have confidence that you are on track to meet your financial goals. Contact us today.