The majority of American citizens pay taxes on social security benefits. Americans often pay income tax on approximately half to 85% of their social security because their total income from other sources plus the amount received as social security adds up to be greater than the minimum threshold required to levy taxes. However, one can use some strategies and free themselves from paying heavy taxes on their social security benefits. This article explains all you can do to limit the amount of income taxes you may have to incur after retirement. Before we get to that, let us understand the extent of taxes that may be applicable to you.
What portion of my social security income is taxable?
Since the year 1983, taxation has been levied on social security payments above certain income limits. These income limits were never adjusted for inflation, and hence most people who have other sources of income besides social security benefits pay taxes on the social security payments.
Nevertheless, none of the taxpayers have to pay tax on all of their social security benefits. The highest percentage of benefits taxed is 85%. The Internal Revenue Service (IRS) is the organization that calculates how much of the benefits are taxable. First, your gross income is calculated by adding income from social security benefits and income from other sources. The other income streams can be salary, dividends, interest, self-employed earnings, and other types of taxable income. Any interest which is exempt from tax is also added.
If the total is more than the minimum income for tax, then half or more than half of your social security benefits would be taxable income. You then need to reduce the standard deductions or a list of particular deductions to arrive at net income. The size of the tax you owe depends on where the net income number stands in the federal income tax slabs. The amount of tax also depends on whether you are filing tax as an individual or as a joint couple.
Tax rates for singles filing as individuals
Your benefits would be taxable if you file a tax return as an individual, and your combined income (Sum of income from all other sources, half of the social security benefits, and non-taxable interest) is as follows:
- 50% of your benefits might be taxed if your combined income ranges between $25,000 and $34,000.
- Maximum 85% of your benefits can be taxed if the combined income adds up to over $34,000.
A worksheet created by the IRS can be used to calculate taxable income. You will observe that the taxable income has increased by 50% of your social security benefits if you are an individual with a combined income between $25,000 and $34000 and up to 85% if it is more than $34,000. In the case of couples, the taxable income could increase by 50% if income exceeds $32,000 and till 85% if income exceeds $44,000.
Let us go over an example to understand the concept better. Let’s assume there is an individual taxpayer who receives $15,000 as his social security benefit. He also has an income of $18,000 from other sources. Thus, his gross income will stand at $33,000, and his combined income will be $25,500 (half of the social security benefits will be added to other income). This number comes in the range of $25,000-$34,000; therefore, he falls in the category of 50% taxable benefits. By this rule, $7,500, which is half of his benefits, will be considered taxable income.
Then, the net income will be other income ($18,000), half of the security benefit ($7,500) less standard or itemized deductions.
The tax rate for couples filing jointly
Married couples who file a joint return have taxable benefits according to their combined income in the following ways:
- If the combined income of your spouse and you falls between $32,000 and $44,000, then the taxable benefit is up to 50%.
- If the joint income is more than $44,000, then the taxable percentage of your benefits can go up to 85%.
Again let’s take an example for this case. If you and your spouse have a combined income of $24,000 and other income worth $ 30,000, your gross joint income will add up to $54,000, and combined joint income will be $42,000. Hence, half of your social security benefits (50% for the range of $32,000 to $44,000) that is $12,000 will be regarded as income to be taxed. The net income will be calculated by adding half of the social security benefits ($12,000) with all other income minus standard and/or itemized deductions.
Are benefits other than social security taxable?
There are other programs besides social security benefits such as spousal, survivor, and disability benefits that follow similar rules followed under the social security program for retirees. Supplemental Security Income (SSI) is a separate program for disabled people, and the payments derived from it are not taxed.
Spousal benefits are taxed as you read under the Married Tax rates. Survivor benefits that are paid to children do not come under taxable income since the children often do not have any other source of income which makes their total income come under the taxable range. The guardians who receive the benefits in place of the child do not need to describe the benefits as income.
Social security benefits for disabled people are taxable if the receiver has a gross income that is above the minimum threshold. The current minimum required levels of income are $25000 for individuals and $32,000 for couples who file tax returns jointly.
As for SSI (Supplemental Security Income), it is not a social security benefits program. Instead, it is a program to fulfill the needs of people above the age of 65, disabled or blind. These benefits are non-taxable.
How to pay taxes on social security
To know whether you need to pay income tax on your benefits, you should make sure to get a social security Benefit Statement (Form SSA-10990 every January). The form provides details of the benefits you received in the previous tax year. You can also avail the information online after enrolling on the social security website.
You can either make quarterly payments to the IRS or opt for having your federal taxes withheld from your social security payouts before receiving them.
State taxes on social security
State taxes on social security benefits may be levied in these thirteen States – Connecticut, New Mexico, Colorado, Missouri, Minnesota, Kansas, Rhode Island, Vermont, North Dakota, Montana, Nebraska, West Virginia, and Utah. Hence it is important to review with state tax agencies before paying your taxes. You will not owe state taxes if you live in the remaining 37 states.
3 ways to minimize taxes on benefits
Keeping your total combined income below the minimum required income limits for taxes to kick in is a straightforward way to avoid paying taxes on your benefits. This is easier said than done in most cases. Even so, there are ways to minimize the amount of taxes that you owe.
Following are three solutions that people can adopt to minimize their tax benefits:
1. Retain some portion of retirement income in Roth accounts
A Roth account is an individual retirement account that, provided certain necessary conditions are met, allows tax-free qualified withdrawals. Deposits to IRA accounts such as Roth 401(k) and Roth IRA are made from income left after tax deductions. Hence, withdrawals from these accounts do not attract any taxes. However, the distributions from the Roth Accounts are free of tax only if you make withdrawals after you reach 59 and half years of age and have held the account for at least five years.
The Major distinction between Roth IRAs and traditional IRAs is that distributions from the latter are taxable since the deposits are made from pre-tax income. Therefore, keeping some retirement income in Roth accounts will not complicate your calculation to get taxable income and also help in limiting the taxes you need to pay on social security benefits.
Due to this advantage, it would be wise to have a mix of both Roth Accounts and regular retirement accounts well before you retire, as such a combination will provide you with increased flexibility to oversee withdrawals from each of these accounts and limit the amount of taxes on social security benefits.
Other good alternatives to holding your retirement savings are money market accounts, conventional savings accounts, and tax-sheltered accounts.
2. Withdrawing taxable income before retiring
Increasing your taxable income before you start receiving your social benefits at the time of retirement is one of the solutions to lessen your taxable income while taking social security benefits. A person could be earning maximum income between the ages of 59 till retirement, so he should withdraw a large portion out of his retirement account, pay taxes on it and then use it after retirement without incurring additional taxes on it.
For instance, one could withdraw funds in the pre-retirement period from tax-sheltered accounts like 401(k) and IRA. After you reach 59 and half years of age, you can withdraw amounts tax-free. Thus, you end up paying fewer taxes once you begin receiving security benefits since you have already paid taxes on the portion you withdrew in the pre-retirement period. However, the amounts of withdrawal should be carefully planned while looking out for other taxes that you will need to pay that year.
By applying the above-mentioned strategy, you can boost your income when you are nearing the time of retirement and, as a result, would be able to afford to delay applying for social security benefits. The later you apply for social security benefits, the larger is the number of sums you receive after retirement.
3. Buying an annuity contract
You can opt for a qualified longevity annuity contract long for QLAC, which is a type of annuity contract that ensures that you do not outlive your retirement fund. This annuity provides you with a regular and steady distribution of income. The advantage of these contracts is that their payments are sheltered from sudden market downturns and fluctuations.
The annuity contract is free from the minimum required distribution rules listed down by the IRS as long as it complies with certain requirements. The rules will be applied once the annuity payments start. Since there are fixed distributions under an annuity, the combined taxable income is less, which reduces the taxes levied on social security benefits. You can spend $135,000 or 25% of your retirement savings account or IRA to invest in a QLAC that involves a single premium. The amount of benefit you derive from the annuity depends on the number of years you live.
One can defer QLAC income up until the age of 85. You can also add a joint annuitant in the contract who can also be covered under the QLAC irrespective of how long either one lives.
The aim of buying a QLAC should not solely be to reduce taxes on benefits since it has its own sets of advantages and disadvantages. Thus, an individual should be mindful of making such investment decisions and preferably consult a retirement advisor before making any decisions.
Though a majority of American citizens pay taxes on social security benefits, know that there are various strategies that one can employ to reduce the tax amount that you may have to pay as you walk towards your retirement. Analyzing what part of your social security is actually taxable and the various tax rates applicable for individuals and joint applicants can help you through the process. It’s good to know that programs besides social security benefits such as spousal, survivor, and disability benefits follow a similar guideline to social security programs for retirees that helps you reduce your taxable income on paper further. The top three ways to minimize your tax benefits will be retaining, withdrawing, and investing on annuity contracts way before you retire.
To get in touch with a fiduciary advisor who can help you manage your financial effectively through suitable financial planning strategies, use Paladin Registry’s Free Advisor Match Tool and get connected with 1-3 financial advisors that may be able to help you.
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