Social Security benefits are taxable for most Americans. The thresholds where you begin to owe taxes are very low for Social Security benefits, so it is very easy for Americans with other sources of income to owe taxes on as much as 50% or even 85% of their Social Security benefits. The good news is that you can use strategies before and after you retire that will lower your tax burden.
In 1983, the government began to tax Social Security benefits if they fell above the required income limits. The government has not been adjusting these taxes for inflation in that time period, so the majority of Americans do owe taxes on their Social Security benefits.
The entire amount that you receive from Social Security will not be taxed, and it doesn’t matter if you are a millionaire. However, the highest taxable level is 85% of the total benefit.
How Does the IRS Calculate Your Taxes?
The Internal Revenue Service or IRS will calculate your taxes by first combining your income from Social Security and all of your other sources. This is known as your “adjusted gross income,” and it includes some retirement accounts, required minimum distributions, dividends, interest, self-employment earnings and wages.
Then, the IRS adds tax-exempt interest.
The total would need to exceed the minimum taxable levels for 50% of your taxable income to be taxable. To determine your net income, you would need to itemize deductions or take the standard deduction. The amount that you may owe the government will depend on where your income falls in the government’s tax tables.
Paying Your Social Security Taxes.
In January, the IRS will send you a Social Security Benefit Statement that explains the benefits that you received during the previous year, and it will let you know whether or not you owe taxes on this amount. You can also find out this information when you enroll on the website for the Social Security Administration. You can either have your Social Security taxes removed from each check, or you can pay Social Security taxes on a quarterly basis.
Do You Owe State Taxes on Social Security Benefits?
West Virginia, Vermont, Utah, Rhode Island, New Mexico, Nebraska, Montana, Missouri, Minnesota, Kansas, Connecticut and Colorado tax Social Security benefits for some Americans. You will need to contact your state tax agency to find out if your benefits will be taxed.
How Do You Avoid Paying Taxes on Social Security Benefits?
You can limit your Social Security taxes in the following three ways:
Make Sure that There Is Money in Your ROTH Accounts.
The money that you funded your ROTH IRA or ROTH 401(k) were after-tax dollars, so this money is not subject to being taxed later. If you are taking this money after you turn 59½ and have had the account for at least five years, your benefits will not be taxed. Your ROTH payouts will not affect the taxes that you owe.
Because ROTH accounts give you these advantages, it is a wise plan to have ROTH accounts as well as regular retirement accounts long before you retire. It will minimize the amount of taxes you will owe, but it will also make managing withdrawals from several accounts more flexible.
Take Withdrawals from Your Taxable Income before You Retire.
Maximize or increase your taxable income years before you begin to receive your Social Security benefits. One way to do this is to take distributions from your tax-sheltered retirement accounts. After you turn 59½, you can take these distributions without receiving a penalty. Therefore, you will not be penalized for making early withdrawals, but you will still be required to pay income taxes on the amount that you withdraw. In addition to lowering your taxes, this strategy will also allow you to take Social Security payments later, and this will qualify you for larger payments later on.
Invest in an Annuity Contract.
You can purchase a qualified longevity annuity contract or QLAC. A QLAC is a deferred annuity that you will fund with money that you take from an IRA or a qualified retirement plan. QLACs are advantageous because they aren’t susceptible to market downturns, and they offer you monthly payments for the rest of your life. If your QLAC adheres to IRS requirements, you aren’t required to take required minimum distributions until you start taking payouts after the specified annuity starting date begins.
This financial vehicle limits the number of distributions you take, so it reduces your taxable income when you are in your retirement years. Therefore, it reduces the amount that you have to pay in income taxes on your Social Security benefits.
Although the QLAC will help you lower your Social Security taxes, you must not purchase one just for this reason. You will have advantages and disadvantages when purchasing a retirement annuity, so you must make this decision carefully with a financial advisor to determine if it is something that is right for you.