How to Minimize Taxes on Your Benefits

One of the less pleasant surprises in retirement is that Social Security benefits can be taxable. Depending on your total income, up to 85% of your Social Security benefits could be subject to federal taxes. For many retirees, this tax bite can be a shock, especially if they were expecting to live tax-free off their benefits. But the good news is, with some strategic planning, you can minimize the taxes you owe on your Social Security income.

In this article, we’ll break down how Social Security benefits are taxed, explain the income thresholds to watch out for, and offer strategies to reduce or eliminate taxes on your benefits.

How Social Security Benefits Are Taxed

Whether your Social Security benefits are taxed depends on your provisional income. Provisional income is a calculation the IRS uses to determine how much of your benefits are taxable. It includes the following:

• Your adjusted gross income (AGI), which is income from wages, interest, dividends, pensions, and other taxable income.
• Nontaxable interest, such as interest from municipal bonds.
• Half of your Social Security benefits.

Once you’ve added these up, your provisional income will determine how much of your Social Security benefits are taxable.

Here’s the breakdown:

• If your provisional income is less than $25,000 (for individuals) or less than $32,000 (for married couples filing jointly), your Social Security benefits aren’t taxed.
• If your provisional income is between $25,000 and $34,000 (for individuals) or $32,000 and $44,000 (for married couples), up to 50% of your benefits may be taxed.
• If your provisional income exceeds $34,000 (for individuals) or $44,000 (for married couples), up to 85% of your benefits may be taxed.

How to Minimize Taxes on Your Social Security Benefits

While you can’t always avoid taxes on your Social Security benefits, there are strategies you can use to minimize the tax burden. The key is to manage your income from other sources carefully so your provisional income stays below the taxable thresholds as much as possible. Here’s how you can do that:

Adjust Your Retirement Withdrawals

One of the most effective ways to minimize taxes on Social Security benefits is to control when and how you withdraw money from your retirement accounts. Here’s how this can work:

• Withdraw from Roth accounts - If you have a Roth IRA or Roth 401(k), withdrawals from these accounts don’t count toward your provisional income because they’re tax-free. By using funds from your Roth accounts instead of tax-deferred accounts like traditional IRAs or 401(k)s, you can keep your income lower and reduce the amount of your Social Security that’s taxable.

• Strategic withdrawals from tax-deferred accounts - Traditional IRA and 401(k) withdrawals count as taxable income and will raise your provisional income. However, if you can take smaller distributions over time, you might be able to spread out your taxable income and avoid triggering higher taxes on your Social Security benefits.

• Delay Required Minimum Distributions (RMDs) - Once you turn 73, you must start taking RMDs from your traditional IRA or 401(k). These withdrawals are counted as income, which could push you into a higher provisional income bracket. To avoid this, consider drawing down those accounts before you reach 73 to reduce the size of future RMDs.

Be Mindful of Investment Income

Income from interest, dividends, and capital gains can increase your provisional income and, in turn, the portion of your Social Security benefits that’s taxable. If you have significant investment income, consider these strategies:

• Tax-efficient investing - Shifting your investments into tax-efficient options, such as tax-free municipal bonds or tax-managed mutual funds, can help reduce your taxable income. This can keep your provisional income lower and reduce your Social Security tax liability.

• Harvest capital gains carefully - If you need to sell investments, be mindful of the capital gains tax hit. By spreading out the sales of appreciated investments over multiple years, you can avoid bumping up your income in any single year, which could trigger higher taxes on your Social Security benefits.

Consider Roth Conversions Early in Retirement

Another option is to convert funds from a traditional IRA or 401(k) into a Roth IRA in the early years of retirement - before you start claiming Social Security benefits or are subject to RMDs. Roth conversions are taxable, but once the money is in a Roth IRA, future withdrawals won’t count as taxable income.

This strategy allows you to pay lower taxes on your retirement savings before you start collecting Social Security and enjoy tax-free withdrawals from your Roth account later on. Reducing your taxable income in your later years can minimize taxes on your Social Security benefits.

Delay Social Security

If you don’t need your Social Security benefits right away, delaying your claim until age 70 can help in two ways. First, you’ll increase your monthly benefit by 8% for every year you delay past Full Retirement Age, giving you more income later. Second, delaying Social Security while drawing from other income sources (such as a traditional IRA or 401(k)) could allow you to reduce the size of future RMDs and manage your taxable income more efficiently.

This strategy works particularly well if you have other income to live on in the early years of retirement, such as savings or investments. By delaying Social Security, you might be able to keep your provisional income lower in the years when you finally start claiming benefits.

Understand State Taxes on Social Security

While we’ve focused on federal taxes, it’s important to note that some states also tax Social Security benefits. Currently, 12 states tax some portion of Social Security income. These states include Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, Rhode Island, Utah, Vermont, and West Virginia.

If you live in one of these states, it’s important to understand the specific tax rules that apply to Social Security benefits. Some states offer exemptions or income thresholds similar to the federal system. In contrast, others may tax some of your benefits regardless of income.

If you’re considering moving in retirement, the Social Security benefits tax treatment in your new state should be a consideration.

Key Points

• Social Security benefits may be taxable depending on your provisional income, which includes your adjusted gross income, nontaxable interest, and half of your Social Security benefits.

• Up to 85% of your Social Security benefits could be taxed if your provisional income exceeds $34,000 for individuals or $44,000 for married couples.

• Strategies to reduce taxable income (such as Roth conversions, tax-efficient investing, and strategic withdrawals from retirement accounts) can help minimize the taxes you owe on your Social Security benefits.

• Be mindful of how Required Minimum Distributions (RMDs), investment income and charitable giving can impact your provisional income.

• Understanding both federal and state tax rules for Social Security can help you keep more of your benefits in retirement.

The Takeaway

Taxes on Social Security benefits can take a bite out of your retirement income. Still, with careful planning, you can minimize the impact. By managing your retirement income streams and using tax-efficient strategies, you can keep your provisional income low and reduce the taxes you owe on your benefits.