How are taxes on Social Security benefits calculated? Are there any strategies that would help me avoid paying taxes on my benefits?
Whether your Social Security benefits are taxed depends on your "provisional income." Your provisional income is your adjusted gross income, not counting Social Security benefits, plus nontaxable interest and half of your Social Security benefits. If it's below $25,000 and you file taxes as single or head of household, or less than $32,000 if you file a joint return, you won't owe taxes on your benefits. If your provisional income is between $25,000 and $34,000 if you're single, or between $32,000 and $44,000 if you file jointly, up to 50% of your benefits may be taxable. If your provisional income is more than $34,000 if single or more than $44,000 if married filing jointly, up to 85% of your Social Security benefits may be taxable. For more information about the tax rules for Social Security benefits, see Taxes on Social Security Can Be a Costly Retirement Surprise.
A few strategies can help you keep your income below the cutoffs and reduce the portion of your benefits that is taxable.
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Give your RMD to charity. People who are 70½ or older can give up to $100,000 per year to charity from their IRAs tax-free; the gift counts as the required minimum distribution but isn’t included in your adjusted gross income. See Donate Your RMD Tax-Free to Charity in 2016 for more information.
Buy a QLAC. You can invest up to $125,000 from your IRA or 401(k) in a special version of a deferred-income annuity called a Qualified Longevity Annuity Contract (QLAC). Money in a QLAC is ignored when figuring your RMD, so you can reduce the size of your RMD, lower your income and trim your tax bill. Payouts don’t start for several years – as late as age 85 – when they will be included in your taxable income. See New Annuity Product Provides an Income Stream for a Long Life for more information.
Withdraw money from tax-free Roths. Tax-free withdrawals from a Roth IRA or Roth 401(k) are not included in your AGI. Rolling over money from a traditional IRA or 401(k) to a Roth years before you start receiving Social Security benefits is a good way to avoid taxes later in retirement. You'll have to pay income taxes in the year of the conversion, but you can tap the account tax-free after that.
Be careful with income investments. You could structure your portfolio to minimize the income it generates, especially if that income is being reinvested, says Tim Steffen, director of financial planning for Robert W. Baird & Co. "You're just recognizing income you don't need, and triggering taxes you don't want to pay," he says. "A growth-oriented portfolio may make more sense." Also keep in mind that nontaxable interest, such as interest on municipal bonds, is included when calculating the taxes on your Social Security benefits.
Put your tax moves into perspective. If your income is well over the $44,000 threshold, there likely isn't anything you can do to get yourself below that level, says Steffen. "Don't just focus on Social Security taxes, but instead focus on tax-efficiency overall," he says.
For details about how to calculate your taxable Social Security benefits, see the worksheet in IRS Publication 915 (opens in new tab). Also see the Social Security Benefits Planner: Income Taxes and Your Social Security Benefits (opens in new tab).
Also find out whether the benefits are subject to state income taxes. Most states do not tax Social Security benefits, but 13 states do. See our State-by-State Guide to Taxes on Retirees to find out if your state is on the list.
Got a question? Ask Kim at askkim@kiplinger.com.
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