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For many older Americans, Social Security payments are a financial lifeline. They may also be taxable income, which can come as an unpleasant surprise to new beneficiaries unaware that the IRS can take a bite out of their benefits.
That doesn’t apply to all Social Security recipients. If your overall income is below certain thresholds, you pay zero taxes on your benefits. Unfortunately, those thresholds are pretty low.
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Under federal law, Social Security benefits are taxable if your “combined income” — adjusted gross income (AGI) plus nontaxable interest plus half of your benefits — is at least $25,000 for an individual taxpayer and $32,000 for a married couple filing jointly.
Below that level, benefits aren’t taxed. (Most people with income only from Social Security are in this category.) If your combined income is $25,000 to $34,000 (single) or $32,000 to $44,000 (couple), up to 50 percent of what you get from Social Security is taxable. Above $34,000 for single filers and $44,000 for couples, up to 85 percent of benefits are taxable.
Those rules mean retirees have options to reduce or eliminate the tax burden on their benefits. In a nutshell: “It’s about reducing your income,” says Tim Steffen, director of advanced planning for wealth management firm Baird.
Reducing income isn’t always the best thing for your financial health, and if what you’re bringing in is well above the IRS income thresholds, there’s really not much you can do to avoid paying tax on your benefits.
But if your income is close to one of the taxability thresholds, lowering your AGI via investment moves, tax-friendly retirement account distributions or other means could shield more of your benefits (or future benefits) from the IRS. Here are some of the options.
1. Prioritize withdrawals from tax-free retirement accounts.
If it’s an option, take distributions from a Roth 401(k) or Roth IRA rather than a traditional retirement account.
The beauty of a Roth is that withdrawals are tax-free, as long as the account has been open for at least five years. That means any distributions you take are “not going to count as taxable income when it comes to the Social Security calculation,” says Nicole Birkett-Brunkhorst, a wealth planner at U.S. Bank and a registered Social Security analyst.
If your income derives solely from Social Security and a tax-free Roth account, you have a good chance of keeping the taxable portion of your benefits close to zero, according to Noah Harden, regional wealth planning manager at Comerica Bank.