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Social Security income used to be tax-free to all, but that’s no longer the case. Depending on your other income, you could wind up paying tax on up to 85% of your Social Security benefits, at a time when you need steady income the most. However, your qualified tax professional may be able to help you map out a strategy that will reduce your exposure to federal income tax on your Social Security benefits.
According to the Social Security Administration (SSA), about one-third of people who receive Social Security benefits have to pay income taxes on their benefits.
If you file a federal tax return as “single,” and your combined income is between $25,000 and $34,000, you may have to pay taxes on 50 percent of your Social Security benefits. If your combined income is more than $34,000, up to 85 percent of your Social Security benefits are subject to income tax.
If you file a joint return, you may have to pay taxes on 50 percent of your benefits if you and your spouse have a combined income that is between $32,000 and $44,000. If your “combined income” is more than $44,000, up to 85 percent of your Social Security benefits are subject to income tax.
Each year, the SSA sends individuals a Statement of Social Security Benefits. You can use this Statement along with your earnings report to determine if your combined income may be subject to taxation. You can also check online at https://www.ssa.gov/myaccount/
If there is a chance that your Social Security income will be subject to federal income tax, you may be able to reduce your exposure by using the following techniques to reduce your income level:
Consider switching some funds into investments (such as annuities) that pay monthly amounts that include a tax-free return of capital component. That part of each annuity payment representing your investment is not currently taxed and is not factored into the calculation of how much Social Security income is subject to tax.
If you currently are not expending all of your investment income on living expenses, defer as much income as possible. For example, the interest buildup in U.S. Government Series EE bonds isn’t taxed until the bonds are redeemed. In addition, defer taking cash out of your IRAs and qualified plan accounts as long as possible.
If you have the choice, consider withdrawing interest from your municipal bond funds before withdrawing cash from IRAs for living expenses. This helps because municipal bond interest you earn is taken into account when computing the tax on Social Security benefits, but interest and dividends accumulating in an IRA account are not taken into account.
Of course, always bear in mind that taxes should never be the motivating factor behind an investment decision. It’s important to consider your financial, investment, and tax situation in detail before you use one of these techniques.