Each year more seniors pay taxes on Social Security benefits than did the year before, and those who already were taxed pay more. That is an inevitable result of the way the tax is structured, unless you take action to reverse things.
The benefits are taxable when adjusted gross income exceeds certain levels. One big problem is that the levels at which the tax kicks in are not indexed for inflation. As income rises with inflation and economic growth, the tax on Social Security benefits increases.
Up to 50% of Social Security benefits are taxed when the adjusted gross income for a single person exceeds $25,000 ($32,000 for other taxpayers). Up to 85% of benefits are included in gross income when adjusted income exceeds $34,000 for single taxpayers ($44,000 for others).
The tax on Social Security benefits gives seniors the highest marginal tax rates. The marginal tax rate is the tax imposed on the last dollar earned. Suppose your income is at the level at which Social Security is tax free. In the last week of the year, you get some unexpected income that pushes you above the threshold at which up to 50% of benefits will be taxed. This means for every additional dollar earned, fifty cents of Social Security benefits also will be taxed. You pay taxes on $1.50 for each new dollar of income.
Suppose now that you already were in the range where up to 50% of benefits are taxed. New income moves you above the threshold for the tax on 85% of benefits. In that case, $1.85 of income is taxed for each new dollar earned.
In these situations, your combined federal and state income tax rate is quite high. I regularly hear from readers in high tax states who are in marginal tax brackets of 70% and higher because of this tax.
Fortunately, there are steps that will reduce the tax on Social Security benefits. The first step is to compute the potential tax on your benefits. The tax is a bit complicated, and details are in IRS Publication 915. Also, check how your state taxes the benefits. Some follow the federal formula. Others completely exempt the benefits.
Let’s dispose of some strategies that don’t work.
Putting all your income investments into exempt bonds won’t eliminate the tax. Congress anticipated this and said that exempt interest will be added to adjusted gross income when determining the amount of Social Security benefits to be taxed. If you are just above the threshold, moving into exempt bonds might bring you below it, because they pay less interest than comparable taxable bonds. Otherwise, the strategy won’t help.
Married taxpayers filing separate returns won’t work. It will increases taxes because the income threshold on a separate return is $0. All income above that triggers taxes on Social Security. Having only the spouse with no separate income receive benefits also doesn’t help. The joint income of a married couple determines the taxable benefits, not the income of each spouse.
Reducing adjusted gross income will reduce the tax on benefits. Strategies that reduce adjusted gross income, in fact, will reduce both regular income taxes and the amount of taxable benefits.
One valuable strategy is tax deferral. Try to avoid recognizing any income that isn’t needed for spending. There are many ways to defer income.
If you are employed, maximizing the use of 401(k)s and other retirement plans will defer income. A nonqualified deferred compensation agreement also is a possibility with some employers. Be sure to get good legal and tax advice before entering into one of these.
Investment income also can be deferred when it exceeds spending needs for the year.
Bond investments can be shifted to fixed or immediate annuities. That keeps unneeded income compounding tax deferred. In addition, if the annuity is annuitized, so that regular payments are received, part of each payment will be tax-free return of principal instead of taxable interest. Review past issues or the archive on the web site for details about buying annuities.
Income from taxable investments also can be deferred. When selecting mutual funds, have a bias toward equity mutual funds that make low distributions each year. Index funds generally have low distributions. Many value funds have low turnover, which results in low distributions. The value funds I recommend traditionally have low turnover and low distributions. Some mutual fund firms, such as Vanguard, offer tax managed funds that are designed to make small distributions.
You don’t want to give up good returns just for tax benefits. But there are many good funds that offer both solid returns and tax efficiency.
Consider the tax effects of your overall investment strategy. Selling a winning investment will result in a taxable capital gain and might trigger taxes on Social Security benefits. Make the move only if the expected return of the new investment will overcome these taxes. Otherwise, you are better off holding the old investment and avoiding the taxes.
IRA distributions might exceed your spending needs and the required minimum distributions. If so, consider reducing the distributions. I’ve explained in the past how over the long term it can pay to empty an IRA early or take larger than needed distributions now to reduce taxes on required distributions down the road. If you aren’t in a situation when those strategies are appropriate, consider carefully managing the distributions so that they don’t exceed spending needs.
Some deductions also can shelter Social Security benefits from taxes.
Capital losses shelter capital gains plus up to $3,000 of other income. Selling a losing investment or two could save some of your benefits from taxes. If you like the investment long term, it can be repurchased after more than 30 days have passed.
Business losses also can be deducted in full against all types of income. Some retirees turn hobbies into part-time businesses. You can deduct any losses from operating such a business if you are operating the business in a professional manner with the intent of making a profit. Or you are entitled to deduct the losses if you make a profit in at least two out of the last five consecutive years.
These are the main deductions that will reduce taxes on Social Security benefits.
Taxes on Social Security benefits do not have to drive you into the 70% or higher marginal tax bracket. A few simple steps can help you avoid that fate.