Financial Planning

Uncle Sam’s Bite of Social Security

Retirement surprise: As much as 85% of Social Security benefits are subject to tax when provisional income exceeds $34,000 on a single return or $44,000 on a joint return.

After a lifetime of paying taxes on wages and other income, many people enter retirement expecting their Social Security benefits to be tax-free, but that’s often not the case. For some retirees, Uncle Sam takes a hefty bite of those benefits. Fortunately, there are ways to lower the percentage of Social Security payments that are subject to federal tax.

Start with calculating the taxable amount by adding together 50% of your Social Security benefits, all tax-exempt interest and other items that make up your adjusted gross income (minus certain deductions like those for higher education). The result is your provisional income.

Social Security benefits are not taxed for single filers with provisional incomes of less than $25,000. The same is true for married couples filing jointly if their provisional income is less than $32,000. When provisional income is between $25,000 and $34,000 for a single filer, or $32,000 and $44,000 for a joint filer, up to 50% of Social Security benefits can be taxed. As much as 85% of those benefits are subject to tax when provisional income exceeds $34,000 on a single return or $44,000 on a joint return.

Reducing adjusted gross income is the key to lowering taxes on Social Security. If your AGI drops, so does your provisional income. When your provisional income shrinks, the percentage of benefits included in taxable income declines, lowering the tax on benefits.

Your strategy for reducing the tax should be put in place long before your first Social Security check arrives. Matt Nadeau, wealth adviser at the Piershale Financial Group in Barrington, Ill., often recommends pre-retirement Roth conversions. Shifting money from a traditional IRA to a Roth IRA generally makes sense, he says, because the Roth’s tax-free withdrawals won’t raise AGI.

Simply delaying Social Security can help. The longer you wait, the more you’ll get per month. “If your Social Security is higher and it allows you to take less from a retirement account like an IRA, that lowers provisional income” because you have less taxable money from a traditional IRA boosting your AGI, says Nadeau.

Once you start taking Social Security and are at least 70½ years old, qualified charitable distributions are a great way to cut taxes on those benefits if you are taking money from a traditional IRA and plan to give to charity anyway. With a QCD, you can transfer up to $100,000 directly from a traditional IRA to charity without raising your AGI, whereas if you took $1,000 from your IRA and donated it separately “that $1,000 might be making another $850 of your Social Security taxable,” warns Ryan McKeown, senior vice president at Wealth Enhancement Group in Mankato, Minn. 

Tax-efficient investing can also help you keep more of your Social Security benefits. For example, because dividends are included in AGI, Nadeau suggests investing for growth rather than dividend income in after-tax retirement accounts. If you’re working part-time in retirement, which by itself will increase income, continuing to fund a traditional IRA helps dial back your AGI.

Monitoring the capital gains on your investments is also important, says McKeown. “Long-term capital gain is something people can control, because they make a choice to sell an investment.” Even if you qualify for the 0% tax rate on capital gains, McKeown warns, you could still be upping the tax on Social Security benefits by selling capital assets. One way around this is to sell some stocks at a loss, if you can, to offset capital gains.

“All the decisions need to be put in context of an overall plan,” notes McKeown. “Make sure that things make sense for your goals and have investment merit” because there’s more to sound financial planning than just lowering taxes.

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