Did you know that you may be required to pay taxes on a portion of your Social Security benefits? In fact, up to 85 percent of your Social Security income may be taxable. Fortunately, the following strategies can help you lower your tax exposure and maximize your Social Security benefits.
1. Be aware of the Social Security income thresholds.
Social Security taxes are determined based on your annual “combined income,” which is determined using the following formula: adjusted gross income (AGI) + nontaxable interest + half of Social Security benefit = combined income.
Your AGI includes income from all taxable sources, such as wages, withdrawals from tax-deferred retirement accounts (such as traditional IRAs and 401ks), and taxable investment income (such as stock dividends and interest from taxable accounts). Nontaxable interest includes income from municipal bonds. Although free from federal and possibly state income taxes, municipal bond income is counted when calculating the taxable amount of Social Security.
2. Delay your benefits.
If you have additional sources of retirement savings, consider drawing on those during the first few years of retirement and delaying taking Social Security. By drawing down other taxable assets, you may be able to lower your combined income in order to reduce the amount of Social Security subject to taxes. Another benefit of delaying Social Security is that you’ll likely receive a higher monthly benefit amount once you begin receiving payments. Your benefit increases by up to 8 percent each year you postpone beyond your full retirement age (up to age 70), and your cost-of-living increases will also be greater.
3. Consider a Roth conversion.
Withdrawals from tax-deferred accounts (such as traditional IRAs and 401ks) count toward your AGI because those assets have never been taxed. However, withdrawals from Roth sources are tax-exempt because contributions to those accounts are made with after-tax funds.
In the years leading up to retirement, it may make sense to convert a portion of your tax-deferred assets to a Roth IRA. In order to complete a Roth conversion, you must pay taxes in the current year on any amount you withdraw from a traditional IRA to fund the Roth IRA. This is a significant tax event that can have unintended consequences if not carefully executed. That’s why it’s important to work with a qualified wealth manager who can advise you on the best timing and approach based on your specific financial situation. The benefit of this strategy is that, once converted to a Roth IRA, funds continue growing for your retirement and can be withdrawn as retirement income without increasing combined income and, consequently, your Social Security tax exposure.
4. Make qualified charitable distributions (QCDs).
If your retirement goals include supporting charitable causes, you may want to consider making a direct donation from your IRA to a charity. This strategy is referred to as a QCD, and it can help lower your taxable retirement income, which can also lower your Social Security taxes.
At age 73, you must begin taking required minimum distributions (RMDs) from your tax-deferred retirement accounts. Instead of receiving the distribution in your name, which would count toward your combined income for Social Security purposes, you can elect to have the distribution issued directly to your chosen charitable organization. Using this approach, not only can you lower your taxable income, but you can also maximize your charitable impact by contributing pre-tax funds. That’s a win-win for both you and your charity!
Gene Gard, CFA, CFP, CFT-I, is a Partner and Private Wealth Manager with Creative Planning. Creative Planning is one of the nation’s largest Registered Investment Advisory firms providing comprehensive wealth management services to ensure all elements of a client’s financial life are working together, including investments, taxes, estate planning, and risk management. For more information or to request a free, no-obligation consultation, visit CreativePlanning.com.
