Taking Control From the Taxman: Social Security Edition
One of Benjamin Franklin’s many famous quotes convey something that has withstood the test of time, “…nothing can be said to be certain, except death and taxes.” We are so conditioned to pay taxes on income in our lives that many expect nothing different when it comes to Social Security benefits. In reality though, taxes on Social Security income aren’t quite as high as what we pay for wages while working. In fact, many people owe no taxes on Social Security. While it may seem complicated to figure out how much of your benefit is taxable, there are free tools that make it easy. Even better, we can use these tools to strategize how to lower what we must pay to our least favorite uncle, Uncle Sam.
How to Calculate How Much of Social Security is Taxable
Fair warning, this section is for the financial nerds. If you just want the tools and strategies, and not the background, skip ahead to the free tools.
IRS Publication 915 is the “lovely” 33-page document that walks you through the steps to calculate how much of your Social Security is taxable. The first step is to calculate your “Combined Income,” which is your adjusted gross income + nontaxable interest + ½ of your Social Security Benefits. You then take that “Combined Income” number and use the below chart to start to see how much of your benefit is taxable.
|Combined Income||How much of your benefit is taxable?|
|Up to 25,000||None|
|$25,000 to $34,000||Up to 50% of your benefit|
|Over $34,000||Up to 85% of your benefit|
|Combined Income||How much of your benefit is taxable?|
|Up to $32,000||None|
|$32,000 to $44,000||Up to 50% of your benefit|
|Over $44,000||Up to 85% of your benefit|
|Source: Social Security Administration|
The key word in the above chart is “Up To,” as in it is up to 85% of your benefit that may be taxable, not necessarily 85%. It is also not a cliff. What I mean by that is married couples, going from $44,000 to $44,001 in “combined income” does not go from 50% of the benefit taxable to 85% of the benefit taxable just from that $1 extra dollar. How much of your benefit ends up being taxable depends on factors such as the sources and amounts of your combined income.
Free Tools to Estimate Taxes
While you can certainly do the calculations by hand by following the instructions in IRS Publication 915, it is much easier to take advantage of the free tools out there. The IRS has a tool that takes about 5-10 minutes to complete and will estimate how much of your SSI is taxable. While reliable, the IRS tool doesn’t go far enough as it does not help you estimate the bottom line of what you will actually owe to Uncle Sam. My favorite quick estimator is a free application from TurboTax called TaxCaster (the version on your phone or iPad is better than the web version). It is simple to use and simple to make adjustments in order to test various scenarios. If you need even more detailed estimates, a quick search of Google for tax form 1040 excel templates will bring up detailed calculators people have created, but you should be pretty comfortable with tax forms before trying to use these.
Strategies to Reduce Your Social Security Taxes
Using tools to help you estimate your tax bill is good; using tools to test strategies of how to reduce your taxes is even better. By modeling out different strategies in these tools you can find the right mix. Of course, you want to pay what you owe, but there’s no need to leave the IRS an extra tip. Aside from the obvious of “control of your income,” there are a few other initial strategies I think you should consider in order to keep your Social Security taxes lower.
Unlike traditional IRA and 401(k)s, Roth IRA accounts give us the ability to take qualified distributions tax free. Qualified Roth distributions also do not count in the “combined income” formula. If you have saved money into a Roth, these distributions can be used to meet your needs without increasing your taxes. Gaming Roth distributions on an annual basis allows you to control your ultimate tax bracket without sacrificing your retirement income.
Another strategy you could employ revolves around delaying starting your social security. Let’s say you retire on your 66th birthday and wait until you are age 70 to claim your social security benefits. You have 4 years between retirement and social security where your income, and therefore your tax bracket, may be lower before increasing. You can take advantage of these lower income years by either taking distributions from your IRA’s or converting portions of your pre-tax retirement money to Roth IRA’s. Traditional IRA distributions and Roth conversions are taxable so carefully consider how much you can take without pushing you into a higher tax bracket. That said, we want to pay the taxes when we are in a lower bracket versus when we are in a higher bracket. Michelle has a great article related to other considerations regarding Roth Conversions here.
Social Security strategies can get confusing, which is not surprising. The program has been dictated by the government bureaucracy since it was created in 1935. While it can be confusing, there are strategies you can take to help optimize your social security benefit while minimizing your taxes. If you need a hand navigating your options, we are happy to talk to you to see how we can help. To learn more, ask any questions, or provide any feedback, shoot us a message at email@example.com.
This material is provided as a courtesy and for educational purposes only. Neither the named Representative nor Advisory Services Network, LLC gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. Please consult your investment professional, legal or tax advisor for specific information pertaining to your situation.