Social Security income may appear to be your sole reward for a lifetime of payroll tax contributions to the program, but that doesn’t mean Uncle Sam won’t get a cut once you retire and begin receiving benefits.
Depending on your combined income in retirement, you may be required to pay federal taxes on Social Security benefits. In this case, “combined income” refers to the sum of your adjusted gross income (AGI), nontaxable interest, and one-half of your Social Security benefits. Here’s how it applies to federal taxes:
- If you file an individual federal tax return and your combined annual income is between $25,000 and $34,000, you may be required to pay income tax on up to 50% of your benefits. If you earn more than $34,000 per year, up to 85% of your benefits may be taxable.
- If you file a joint return and your combined income is between $32,000 and $44,000, you may be required to pay income tax on up to 50% of your benefits. If you earn more than $44,000, you may be required to pay taxes on up to 85% of your benefits.
According to the AARP, the following states tax Social Security benefits: Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, Rhode Island, Utah, Vermont, and West Virginia.
There are a few options for lowering or eliminating federal taxes on Social Security income. Here are five examples of them.
Keep Your Income Low:
This is the simplest way to avoid paying Social Security taxes entirely — just make sure you don’t exceed the income thresholds mentioned above. This also means that you will have to rely almost entirely on Social Security benefits to pay your bills because withdrawals from pensions, 401(k) accounts, and IRAs, as well as income from investments and interest from other accounts, all count toward your total income.
Withdraw from Tax-Free Roths:
Tax-free qualified distributions from a Roth IRA or Roth 401(k) do not count against your AGI. This reduces both your total income and tax liability. Rolling money from a traditional IRA or 401(k) to a Roth before receiving Social Security benefits is a good way to avoid taxes in retirement. You will receive a tax bill in the year of conversion and may have to wait five years before you can withdraw the funds penalty-free, but after that you will be able to tap into the account tax-free.
Withdraw from Retirement Accounts Before Signing Up for Social Security:
One way to reduce your combined income is to begin withdrawing from IRAs and 401(k)s before you begin receiving Social Security. You can start taking penalty-free distributions as early as 59 1/2, and in some cases as early as 55. In theory, you could withdraw all of your retirement account funds before beginning to receive Social Security benefits, but this is probably not the best long-term strategy if you want to live comfortably.
Purchase a Qualified Longevity Annuity Contract:
Joint filers can invest up to $125,000 from your IRA or 401(k) in a qualified longevity annuity contract, or QLAC, which is a type of deferred-income annuity. Money in a QLAC is not counted when calculating your required minimum distribution. This means you can reduce the size of your RMD, lowering both your income and your tax bill. Payments from a QLAC can be delayed until the age of 85, at which point they will be included in your taxable income.
Avoid Municipal Bonds: Municipal bond interest, which is normally not subject to income taxes, is included in the formula that determines whether you will pay taxes on your Social Security benefits, according to MoneyTalkNews. Avoiding munis can help you reduce your combined income and avoid paying taxes on your benefits.
Avoid Municipal Bonds:
Municipal bond interest, which is normally exempt from income taxes, is factored into the formula that determines whether you will pay taxes on your Social Security benefits. Avoiding munis can help you reduce your total income and avoid paying taxes on your benefits.
Research Source: finance.yahoo.com, msn.com