Uncle Sam’s Bite of Social Security

After paying taxes on wages and other income for most of their lives, many Americans enter retirement expecting their Social Security benefits to be free of taxes. Often that is not the case. For some retirees, Uncle Sam takes a hefty bite out of those benefits. Fortunately, there are ways to lower your percentage of Social Security benefits that are subject to tax.

Start by calculating your provisional income. This is done by adding together 50% of your annual Social Security benefits and your adjusted gross income (AGI). Your provisional income determines how much of your social security benefits are subject to tax.

Single filers with provisional income less than $25,000 and married couples filing jointly with provisional income less than $32,000 receive their benefits tax free. When provisional income is between $25,000 and $34,000 for single filers or between $32,000 and $44,000 for joint filers, up to 50% of Social Security benefits can be subject to tax. Up to 85% of benefits can be taxed if the provisional income is more than $34,000 for single filers or $44,000 for joint filers.

This all means that reducing your adjusted gross income is the key to lowering the taxes you pay on Social Security. A lower AGI means less provisional income, which in turn reduces the percentage of benefits included in taxable income. However, in order to reduce your AGI efficiently, you need a strategy in place long before your first benefits check arrives in your mailbox. Common strategies you will want to consider include delaying Social Security, pre-retirement Roth conversions, tax-efficient investing, and utilizing qualified charitable distributions.

Simply delaying Social Security can help reduce the tax on your benefits. The longer you wait, the more benefits you’ll receive each month. If your benefits are high enough to allow you to take less from your retirement savings, it’ll help lower your AGI and therefore it’ll help reduce your provisional income.

Pre-retirement Roth conversions are an excellent tool for reducing your tax liability over your lifetime. Shifting money from a traditional IRA to a Roth IRA will help reduce your future provisional income because the tax-free withdrawals from the Roth account won’t affect your AGI. This is doubly beneficial for when you reach age 72 and need to start taking required minimum distributions. By reducing the dollar value of your traditional IRA, you also reduce the amount to are forced to withdraw each year.

Qualified charitable distributions are an option for retirees looking to reduce their AGI and are subject to required minimum distributions. If you’re charitably inclined, giving your charitable donation directly from your retirement account allows you to fulfill up to $100,000 of your required minimum distribution without having to recognize the distribution as income.

Tax-efficient investing can also help reduce the tax on Social Security. Dividends earned by your investments held in after-tax retirement accounts are included in AGI so managing dividend income can benefit you come tax time. It is also important to pay attention to capital gains. Even if you’re in the 0% capital gains rate, selling your investments could push your provisional income higher.

All of these options need to be put in the context of an overall retirement plan when trying to make a decision. Be certain that your strategy makes sense for your goals and has investment merit. There’s more to sound financial planning than simply lowering taxes.