Many retirees are finding out the hard way that Social Security is taxable, especially when it moves them into a higher tax bracket.
Take Kate, a potential new client.
“Collecting Social Security might cause you to pay too much income tax,” I said to her during an investment review.
“You mean Social Security is taxable?” she responded.
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“Not for every retiree, but for you, yes. You have a paid-up house, get more income each month than you need for your bills, and, hey, you just told me you’re not into buying a Mercedes or flying business class.”
According to the Social Security Administration, about 52 percent of taxpayers receiving benefits in 2015 include income from Social Security on tax returns.
The good news: It’s possible to use strategies to avoid or reduce the income tax on Social Security. Start by determining if your benefits are taxable.
Begin with calculating your adjusted gross income, gross income before adjustments, deductions and exemptions, add muni-bond interest, and then add 50 percent of Social Security benefits, plus some adjustments, if applicable, for a year.
If this amount, called provisional income, is higher than the government threshold, some of your Social Security, up to 85 percent of that income, could be taxed at rates of 25 percent or more.
Now let’s talk about possible ways to avoid or decrease taxation of Social Security benefits. As always, not all strategies discussed are appropriate for all individuals and situations. Strategies, in my opinion, might benefit married couples with provisional incomes of less than $44,000, and single people with provisional incomes of less than $34,000.
DEFERRED ANNUITY USE
Reducing income taxes on Social Security is possible by replacing investments and generating taxable income with an appropriate deferred annuity. Common features of annuities are lifetime payments, asset accumulation and often state funding guarantees.
Should a life insurance company go south and isn’t able to pay claims, many states have funding guarantees. Less favorable features include inflation affecting annuity payments and fees for management and early-surrender charges. Withdrawals from annuities come first from investment gains, which are taxable, then from principle.
Let’s consider an example of Ryan and Joan, two 65-year-old retirees with a paid-off house and monthly living expenses of $2,000. Ryan and Joan have Social Security benefits of $20,000, taxable pensions of $24,000, $15,000 of interest from savings-account CDs, and tax-exempt municipal income of $10,000. After deducting exemptions and a 2015 standard deduction, Ryan and Joan now pay income tax of about $4,016.
Now let’s see what happens if Ryan and Joan, like many of their neighbors, aren’t spending the $15,000 in CD interest they received. By moving the $15,000 of CD interest received to a deferred annuity, not FDIC insured, the taxes would be reduced to about $693, allowing Ryan and Joan to save close to $3,323 – using 2015 tax rates – of federal income tax.
If I was their financial adviser, I’d suggest using some funds to pay for their grandchildren’s college educations. Growing retirement savings with tax deferred growth is, hopefully, another benefit.
SIMPLE IRAS AND TRADITIONAL IRAS
Still working in your 60s? Assuming, for example, a net income from being self-employed of $40,000, reported on a Schedule C, a Simple IRA contribution would be $12,000 plus an additional $1,108, with 3 percent employer matching. Earned income from part-time jobs or from salaries, if you haven’t retired, enables you to contribute up to $6,500 to a tradition IRA or $13,108 to a Simple IRA.
Tax would be about $10,542, with $14,000 of social security and no IRA, for a single person in this example. With a $6,500 IRA contribution, however, the tax falls to $8,922. And with a $13,608 Simple IRA contribution, the tax further declines to $7,130.
Tax savings for a working retiree might be considerable. In this example, they reduce the amount of taxable social security by $8,867 for someone in a 15 percent tax bracket – this yields tax savings of $1,330. Rates and tax benefits might change next year, though.
Claiming a Section 179 depreciation deduction, a noncash expense, on business property often reduces adjusted gross income for tax purposes. Investing in growth stocks, series EE bonds and Series I bonds, rather than investments creating current income taxed at ordinary rates, might help cut taxes on Social Security benefits.
Some of my senior clients are surprised when they learn that tax-free interest isn’t really tax-free. Please know that your tax preparer must include all municipal bond interest in calculations determining how much of your Social Security benefit is taxable.
DISTRIBUTIONS FROM ROTH IRAS
As long as you are at least 59 ½ and had the Roth account for at least five years, distributions are exempt. These exempt Roth IRA distributions won’t pile on as additional income triggering Social Security to be taxed.
One more way to reduce the taxation of Social Security benefits is to delay collecting them. This will boost benefits in the future. Remember, though, you have to live long enough to enjoy and recoup these benefits.
Use care and prudence when determining if these strategies, including the use of annuities, are worth the tax benefits. Before using these tactics, schedule a review with a financial adviser.