After years of perfect retirement planning, diligent investing, creating detailed budgets, and wisely investing resources, many investors continue to overlook an important detail: up to 85% of Social Security income can be subject to federal (and possibly state) revenue taxes. It can be a real shock when people start getting their benefits.
The taxable portion of your Social Security income depends on various factors, including your federal tax filing status and your adjusted gross income. But with a little planning ahead, which can include anything from rebalancing your portfolio to structuring certain transactions correctly (like a home or business sale), you can reduce the risk of taxes derailing your plans.
How to calculate taxes
Social Security benefit taxes are based on what the Social Security Administration (SSA) calls your "combined" income. It consists of Adjusted Gross Income, which includes (among other things) non-taxable interest and half of Social Security income. Once you exceed the income limits specified in the category you belong to, some of your Social Security benefits will be considered taxable income. For example, a couple who retires and files a joint return with combined income between $32,000 and $44,000 may find that up to 50% of benefit payments are considered taxable income.
Build a long-term strategy
Because of these income limits, tax planning experts often recommend that you look for ways to reduce your combined income. When planning for your retirement, you have to think in terms of multi-year projections. For example, if you anticipate a single major event, such as the sale of a business, it is better to structure the sale as a multi-year payment rather than a cash transaction. This can help you spread your overall income evenly and possibly stay in a lower tax bracket, which can help reduce your portion of your Social Security benefits that are subject to federal income tax.
You may also want to consider a long-term strategy for making withdrawals from your eligible retirement accounts. This is because withdrawals from a traditional IRA will often be included in taxable income calculations. However, qualifying withdrawals from a Roth IRA are generally not included. So if you have both, think twice before opting out of the Roth or the traditional IRA.
A word of warning if you are considering converting from a traditional IRA to a Roth IRA: any amount converted before tax will be considered income in the year of conversion. However, it may be worth it because of the other tax advantages of the Roth IRA. Another option is to convert an investment that generates taxable income, such as a portfolio of taxable bonds, into a tax-deferred account, such as a deferred annuity. You can structure your annuity to start paying income in a few years when you expect your taxable income to decline, as well as your general tax rate.
If you earn pension income, you may still be eligible to contribute to an IRA, and contributions to a traditional IRA may be tax-deductible, reducing your taxable income.
Know your earning limits
Those hoping to retire should be especially careful if they plan to apply for Social Security benefits sooner. Even if you only work part-time, it's important to consider how this ongoing income will affect your benefits.
The SSA limits the amount you can earn if you start receiving benefits before full retirement age, which is 66 for most baby boomers. For 2021, the annual income threshold was $18,960, and for every $2 you earn over that threshold, SSA deducts $1 from the top of your benefit. So if you earned $20,960 in 2021 and you have not reached full retirement age, your benefits will be reduced by $1,000 plus any income tax you have to pay for the remaining benefits. When you reach full retirement age, the accumulated income threshold increases to $50,520, and for every $3 you exceed, there is a $1 withholding tax.
However, there is good news: since your individual earnings determine the penalty if you retire early, but your spouse does not, your spouse's earnings will not be factored into the earning limits. In addition, when you reach full retirement age, your earning limit will disappear, and Social Security will recalculate the amount of your benefit if your earning limits negatively impact you.
Keep in mind that if you file tax returns jointly, your spouse's income will be included in your combined income calculation to determine the taxation of your benefits.
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