When it comes to your retirement, you have a variety of options, such as employer-sponsored retirement savings accounts like a 401(k) plan. But, the largest contributor to retirement income is Social Security. In fact, in 2019, 69.1 million people received benefits from programs administered by the Social Security Administration.
If you’re somewhat familiar with Social Security, it seems straightforward. When you work, you pay taxes on your income. This is then put into a pool and you’ll eventually reap the benefits when it’s time for you to retire. It’s a nice, and often long-waited, perk for paying your dues. But, if you’re not careful, you may get hit by something known as the “tax torpedo.”
In simplest terms, this is an unexpected tax burden where you may have to pay tax on up to 85% of your Social Security benefits depending on the other income you have coming in. Obviously, that can throw a monkey wrench in your retirement plans.
To make sure that you aren’t caught by surprise, here are 5 ways that you can protect yourself from getting sunk by this Social Security tax torpedo.
1. Figure out if you’re a likely target.
“The first step is being aware that this may be an issue,” advises Roger A. Young, CFP® “It may not be obvious, even looking at your tax return or software.” However, one of the most common warning signs is required minimum distributions (RMDs). The reason, adds Young, is because “you have no choice but to receive taxable income.”
You can determine this by calculating your provisional income. To figure this out, simply add your non-social security income, which does include tax-free income like municipal bonds, with 50% of what you’ll receive from Social Security annually.
Expect to be taxed up to 50% of your benefits if your provisional income comes out to:
- $25,000 to $34,000 for single tax filers.
- $32,000 to $44,000 for couples who are filing jointly.
“But wait — it gets a bit worse,” warns Maurie Backman. “You may be subject to taxes on up to 85% of your benefits if your provisional income exceeds $34,000 as a single tax filer or $44,000 as a couple filing jointly.”
“As such, it’s often the case that seniors who have income outside of Social Security ultimately wind up being taxed on their benefits to some degree,” adds Backman.
Do you believe that this applies to you? If yes, then work with a financial planner or tax professional ASAP. They can assist you in fine-tuning “your retirement expense, income, and tax projections,” states Young. “That can help you determine whether additional planning is necessary.”
2. House your retirement savings in a Roth IRA.
After determining if you’ll be struck by the Social Security tax torpedo, you need to make some maneuvers to avoid it. One of the simplest tactics is housing your retirement savings in a Roth IRA.
“Established in 1997, a Roth IRA is simply an individual retirement account (IRA),” explains Chalmers Brown, Co-Founder, and CTO of Due. “Named after its sponsor, Delaware Senator William Roth, it’s similar to a traditional IRA.”
“Both have contribution limits and deadlines,” adds Chalmers. “There are also no minimum investments or fees. However, the key difference is how they’re taxed.”
You pay taxes on the back-end with a traditional IRA. “That’s not the case with a Roth IRA,” he clarifies. “Because you contribute after-tax dollars, your money grows tax-free.” Additionally, “you’re allowed to make tax- and penalty-free withdrawals after age 59½.”
Other pros of a Roth IRA include:
- Savings grow tax-free and you aren’t taxed when make a withdraw in retirement.
- Unlike a traditional IRA, when must pull your money out at age 72, there are no minimum distributions.
- You won’t get penalized if you must make an emergency withdraw.
- “You have the flexibility to juggle your distributions between your accounts,” says Chalmers. “As a result, you can avoid getting placed in a higher tax bracket.”
There are some drawbacks to consider. For example, taxes must be paid upfront and you’ll have to set this up yourself. And, as of 2020, you can only contribute up to $6,000 to a Roth IRA.
Despite the cons, this is a popular way to reduce your Social Security income tax bill. Just make sure to roll your money over into a Roth before receiving Social Security.
3. Stay below taxable thresholds.
Another preemptive measure that you take? Keep your taxable income below the thresholds covered in the first point. You can legitimately do this by:
Retire to a tax-friendly state.
Currently, there are 13 states that will tax your Social Security benefits. These are;
- New Mexico
- North Dakota
- Rhode Island
Just note that even if you relocate to a state that doesn’t tax your Social Security benefits, that’s on the state level. You’re still responsible for federal taxes.
Give your RMD to charity.
For those who are 70½ or older, you’re allowed to donate up to $100,000 annually to charity tax-free. The catch? This must come from a traditional IRA. As a result, this will go towards your required minimum distribution. However, it isn’t included in your adjusted gross income.
Buy a QLAC
“You can invest up to $130,000 (or 25% of your balance) from your IRA or 401(k) in a special version of a deferred-income annuity called a Qualified Longevity Annuity Contract (QLAC),” writes Kimberly Lankford for Kiplinger. “Money in a QLAC is ignored when figuring your RMD, so you can reduce the size of your RMD and lower your taxable income for the year.”
What’s more, you’re permitted to make this investment at any age. And, you’ll “receive annual payouts for your lifetime starting at the age you designate in the future – often in your seventies or eighties.”
“Be aware that you can’t avoid taxes forever on this money,” adds Lankford. “Uncle Sam requires that annual payouts from the QLAC must start no later than age 85, at which point they’re included in your taxable income along with any other RMDs.”
Don’t overload on income investments.
Keep tabs on any income that you earn that comes from investments that are outside of your retirement account(s). “Having a lot of dividends and interest income or capital gains distributions could boost your AGI enough to make a larger portion of your Social Security benefits taxable,” explains Lankford.
“Even nontaxable interest, such as the interest on municipal bonds, is included when calculating the tax on your Social Security benefits,” she adds. “If you’re close to the income thresholds at which more of your Social Security benefits will get taxed and you don’t need the income to live on, consider moving some of your money within taxable accounts into growth-oriented investments that don’t generate as much taxable income each year.”
4. Take money out of pre-tax retirement account between 59 ½ and 70 years of age.
That may go against conventional wisdom. However, “taking funds from these accounts and pay the taxes on them now in an effort to keep the account value down and ultimately the RMD amount lower when Uncle Sam forces you to take it out at 70 ½,” states Scott A. Piggush, WMS. By doing so, you’ll have “the flexibility to control the tax situation each year depending on the rest of your income to keep you in the lowest tax bracket possible.
“One important thing to note here is that if you are not on Medicare yet and are buying your health insurance through the exchange,” advises Piggush. Why? Because “this additional income could reduce your tax credits on that exchange plan.” So, put a pin in that if you are in this situation.
5. Delay Social Security.
Growing up, my grandparents gave their grandchildren cold, hard cash for their birthday. It wasn’t much — usually, it was $50. But, as a kid. That was a fortune. And, I couldn’t wait to spend it — much to the chagrin of my mom.
Looking back, I knew that that money was coming my way. So, I spent months planning on how I was going to put it to use. For some people, the same is true when it comes to collecting Social Security.
You’ve paid into this for years. And, now it’s time to enjoy the fruits of your labor. Besides, there’s that voice in the back of your head tempting you to use it before your passing — or in the off-chance that Social Security will run out.
Instead, try delaying this until your 70. If you’re able to because you can still work, you’ll be able to boost your retirement fund. And, it will also prevent getting hit by the Social Security tax torpedo.
Again, depending on your combined income, up to 85% of your Social Security benefit could be taxed.
“One way to dodge such a tax torpedo is to withdraw less money from your tax-deferred retirement account each year,” notes Donna Freedman. “And delaying claiming Social Security can help you do that because you’ll get a bigger monthly benefit.”