Although retirees may be upset to discover that taxes don’t stop when they leave the workforce, an invisible threat lurks behind the US tax code. The Social Security tax torpedo is as destructive as it looks, blowing up the budgets of unsuspecting retirees who eagerly await their first Social Security check. Having a clear understanding of your Social Security taxes could help you avoid that retirement torpedo. Here’s what you need to know.
A Financial Advisor can help you create a financial plan to minimize your taxes during your golden years.
What is the Social Security tax torpedo?
The Social Security tax torpedo is a tax hike that retirees may experience after receiving Social Security income. Concretely, 50 to 85% of your Social Security check may be taxable, depending on your income level and your living situation. Additionally, your Social Security income may increase your marginal tax rate, meaning the highest portion of your income goes into the next tax bracket. As a result, unsuspecting retirees may pay higher taxes than expected, and their Social Security benefits provide less financial support than expected.
Implications of tax torpedoes
The government bases your retirement taxes on your modified adjusted gross income plus tax-free interest (usually from municipal bonds) and half of your Social Security benefits. The resulting sum is called your “combined income,” which incurs different taxes depending on the amount and the status of the filer.
For example, single filers with a combined income of $25,000 to $34,000 pay taxes on 50% of their benefits. Income above this amount results in taxes on 85% of benefits. Similarly, married individuals filing jointly with combined incomes between $32,000 and $44,000 will pay taxes on 50% of their benefits. Any amount above this amount results in taxes on 85% of the benefits.
Remember, the tax torpedo does not mean you will lose 85% of your Social Security income taxes. Instead, you’ll have to pay your regular income tax rate on 85 cents of every dollar you receive from Social Security. Additionally, your income tax rate is not the same for all your income because of the way tax brackets work. The U.S. tax code imposes progressive taxes on your income, the higher the income.
For example, let’s say you’re a single filer in 2023 with a total taxable income of $50,000 (putting you at the 22% tax rate for income above $44,725). Your combined income is $35,000 and you receive $15,000 in Social Security benefits. You exceed the combined income limit by $34,000, which means you’ll pay taxes on 85% of your Social Security benefits.
This situation requires applying your top marginal tax rate (22%) to 85% of your Social Security benefit ($12,750). So your Social Security tax liability represents an expense of $2,805. If your combined income was $34,000 or less, only half of your Social Security would be taxed, an expense of $1,650.
How to avoid the Social Security tax torpedo
Losing your hard-earned Social Security benefits to Uncle Sam is not inevitable. Here’s how to get around the Social Security tax torpedo while maximizing your financial well-being and quality of life:
Use a Roth IRA
Roth IRA are retirement accounts where contributions are made with after-tax dollars, meaning you don’t get a tax deduction when you contribute. However, distributions during retirement are tax-free. Therefore, your Roth IRA income does not count toward your taxable income, making it less likely that you will exceed the threshold that determines whether 50% or 85% of your Social Security benefits are taxed.
Living in a tax-friendly state
Thirteen States tax your Social Security check, adding to the federal tax burden. As a result, you can save on taxes by avoiding residing in the following states:
-
Colorado
-
Connecticut
-
Kansas
-
Minnesota
-
Missouri
-
Montana
-
Nebraska
-
New Mexico
-
North Dakota
-
Rhode Island
-
Utah
-
Vermont
-
Washington
Donate your IRA income to charity
Qualified charitable distributions (QCD) allow you to give money directly from your traditional IRA to charity. The government does not consider the first $100,000 of donations to be taxable income. Although this will not directly affect your Social Security tax, it will reduce your overall taxable income, potentially reducing the portion of your Social Security benefits that is taxable. Remember, this benefit only applies to traditional IRAs.
Buy a Qualified Longevity Annuity Contract (QLAC)
A QLAC is a specialized annuity that provides guaranteed income later in life. You can transfer $130,000 from a traditional IRA or 401(k) to a newly opened QLAC, reducing the required minimum distributions (RMDs) you will withdraw from your retirement account. This way, distributions from your 401(k) or IRA won’t increase your annual income as much, thereby mitigating Social Security taxes.
Your QLAC has a delayed RMD age compared to traditional retirement accounts. Although the government requires RMDs from a 401(k) or IRA at age 73, you can delay distributions from your QLAC until age 85. Keep in mind that you will owe taxes on QLAC distributions in the year you receive them.
Compare your income level to tax brackets
Understanding the income thresholds for different tax brackets can help you plan withdrawals from retirement accounts. By staying in lower tax brackets, you can reduce the portion of your Social Security benefits that is taxable.
Delay Social Security
Social Security income taxes may only apply when you receive your benefits. SO, delay social security can help you avoid additional taxes until your 60s. If you can work or survive on other income until age 70, you’ll enjoy two benefits: First, you’ll maximize the amount of your Social Security payments. Second, you’ll avoid paying Social Security taxes. Additionally, if you live with a traditional IRA or 401(k) during this time, you will reduce your RMDs, giving you more control over your income level at age 70.
Conclusion
Understanding and proactively addressing the possibility of a Social Security tax torpedo can increase your take-home income during retirement. By using tools like Roth IRAs, charitable giving, and QLACs, you can create a more tax-efficient retirement.
Additionally, being aware of the relationship between your income level and tax brackets and considering delaying Social Security may offer other ways to optimize your financial well-being and quality of life in retirement. Consulting with a financial advisor can be instrumental in tailoring these strategies to your specific situation, helping you maximize your hard-earned retirement benefits.
Tips for Avoiding the Social Security Tax Torpedo
-
Consult a Financial Advisor is a crucial step in planning your retirement and avoiding the Social Security tax torpedo, because you can get personalized advice tailored to your specific financial situation, goals and preferences. Finding a financial advisor doesn’t have to be difficult. The free SmartAsset tool connects you with up to three licensed financial advisors who serve your area, and you can have a free introductory call with your advisor to decide which one seems best for you. If you are ready to find an advisor who can help you achieve your financial goals, start now.
-
Planning during your working years makes a tax-efficient retirement more achievable. However, if you are already retired, you can still lower your taxes and prepare for a better financial future.
Photo credit: ©iStock.com/Inside Creative House, ©iStock.com/ljubaphoto, ©iStock.com/smartstock
The post office How to avoid the Social Security tax torpedo appeared first on SmartReads by SmartAsset.
