Many people are shocked to discover when they begin collecting Social Security that part of their benefits can be taxable. Up to 85% of your Social Security benefits may be taxable at the federal level, depending on your other income. The taxability of Social Security varies from state to state. Most states do not tax it.
IRS has a method to determine if you will pay taxes on your Social Security benefits. Take one-half of your Social Security benefits and add it to your other income. Other income includes wages, interest, dividends, pensions, pre-tax 401k and traditional IRA distributions, net rental income, capital gains, and all taxable income. You must also add in tax-exempt interest when determining how much of your Social Security may be taxable. This combined income number is known as your modified adjusted gross income (MAGI). If the MAGI is over the limit, you will pay taxes on up to 85% of your Social Security benefits.
For single, head of household, or qualifying widow/widower, the limit is $25,000. If MAGI is under $25,000 none of your Social Security is taxable. If MAGI is $25,000 to $34,000, 50% of your Social Security is taxable and MAGI over $34,000 85% of your Social Security is taxable. For example, Mary, a single filer, decides to wait until age 70 to begin collecting Social Security. Mary’s annual Social Security benefits total $26,000. She also receives a $15,000 pension and earns $150 in interest. Half of Mary’s Social Security is $13,000, plus the $15,000, and the $150 gives Mary a MAGI of $28,150. Mary will pay taxes on part of her Social Security benefits because her MAGI is over the limit of $25,000 for a single filer.
For married filing joint filers, the limit is $32,000. If MAGI is under $32,000 none of your Social Security is taxable. If MAGI is $32,000 to $44,000, 50% of your Social Security is taxable and MAGI over $44,000 means 85% of your benefits are taxable. Take Ted and Amy as an example. Ted’s annual benefit is $14,000 and Amy’s annual benefit is $10,500. Both Ted and Amy have 401(K) distributions totaling $5,000 each. Half of Ted and Amy’s combined Social Security benefit is $12,250, plus the $10,000 in 401(K) distributions gives them a MAGI of $22,250. This is under the $32,000 limit and none of Ted and Amy’s Social Security benefits are taxable.
A married filing separate filer who lived with their spouse at any time during the year is going to pay taxes on 85% of the benefits received. The limit for determining the taxability is zero. Some claiming married filing separate living with their spouse automatically is taxed on 85% of their Social Security regardless of income. A married filing separate filer who did not live with this spouse the entire year can use the single filer limit of $25,000 to determine if benefits will be taxed.
Bill and Betty have lived separately for the last two years. Both begin collecting their Social Security benefits. Bill’s annual Social Security benefit is $23,500. Bill also has Traditional IRA distributions of $12,000 and a pension of $30,000 per year. Half of Bill’s Social Security is $11,750. This plus his pension and IRA distribution gives Bill a MAGI of $53,750. Bill is going to pay taxes on his Social Security benefits since he is over the $25,000 limit.
Betty’s annual benefit is $14,000 and she takes 401(K) distributions of $10,000. Half of Betty’s Social Security benefit of $7,000 and her 401(K) distributions of $10,000 gives Betty a MAGI of $17,000. Betty will not have to pay taxes on her Social Security benefits.
There are some ways to reduce your income and can decrease the amount of your Social Security benefits that are taxable. Contributing to a Roth IRA or Roth 401(k0, Roth 403(b) or Roth 457 means your Roth distribution is not taxable.
Sarah made Roth contributions while she was working. Now Sarah has retired and is ready to begin collecting Social Security benefits. Sarah is a single filer with an annual benefit amount of $24,000. Sarah receives a Roth distribution of $15,000, a pension of $10,000, and $100 of tax-exempt interest. Half of Sarah’s Social Security benefit is $12,000, plus her $10,000 pension, and $100 tax-exempt interest gives Sarah a MAGI of $22,100. Because Roth distributions are non-taxable, they do not factor into the calculation. Sarah would pay no taxes on her Social Security.
If Sarah had contributed to a Traditional IRA or a pre-tax retirement plan at work instead of a Roth account, her MAGI would be $37,100. As a single filer, Sarah would be over the $25,000 limit and would have to pay taxes on some of her Social Security.
People with Roth accounts and Traditional IRAs or pre-tax 401(K) can potentially reduce taxable income by doing income distribution planning. Traditional IRAs and pre-tax 401(k) accounts have a required minimum distribution (RMD) beginning at age 72; you must start taking distributions even if you do not need the income at age 72. Roth IRAs do not have a requirement to take distributions at any age.
How can you use this to your advantage? Look at the example of Scott and Nancy, a married filing joint couple. Both Scott and Nancy are collecting Social Security. Scott collects $19,000 and Nancy collects $21,000 annually. At age 72, Scott has an RMD of $3,000 from his Traditional IRA. Nancy has a Roth IRA with no RMD requirement. Neither Scott nor Nancy have any pensions. They know that they need $53,000 of income to pay their expenses.
Scott and Nancy’s combined MAGI is $23,000 (half of their Social Security benefits of $20,000 plus Scott’s required minimum distribution of $3,000). This puts Scott and Nancy under the $32,000 limit for a married filing joint couple and they would pay no taxes on their Social Security.
Scott & Nancy know they need $10,000 more per year to live. Taking $10,000 from Scott’s Traditional IRA would put Scott and Nancy over the $32,000 limit. Half of their Social Security is $20,000, plus Scott’s $3,000 RMD and the optional $10,000 distribution is $33,000. Scott and Nancy’s Social Security benefits would begin being taxed.
If Scott and Nancy took the additional $10,000 out of Nancy’s Roth IRA instead, their MAGI would remain at $23,000 since the Roth IRA distributions are non-taxable. Scott and Nancy get the income they need to live on without causing their Social Security benefits to be taxed.
Taking the time to meet with a tax planner or looking at a tax-efficient income distribution plan with your financial planner can help reduce your taxes in retirement. No one likes paying taxes, so why pay more than you should? Small strategies like these can help you keep more of the retirement dollars you worked hard to save and not lose them to taxes.
