For millions of retirees, Social Security is supposed to be a reliable source of income. But many recipients face an unwanted surprise once they start collecting benefits — taxes.
Taxes on Social Security in retirement can seem like a double blow. After all, the way you earn those benefits is by paying taxes on your wages during your working years. To then have the federal government claw back a portion of those benefits might seem like double taxation, and understandably so.
Worse yet, the income thresholds at which taxes on benefits apply are very low. If your combined income — your adjusted gross income (AGI) plus tax-exempt interest you earn plus 50% of your annual Social Security income — exceeds $25,000 as a single tax-filer or $32,000 as a married couple filing jointly, your benefits are subject to taxes.
This means that any retiree who’s reasonably comfortable probably doesn’t get to keep their benefits in full — even with the new $6,000 senior tax deduction.
If you don’t like the idea of paying taxes on your Social Security benefits, there’s one key move you can make to lower your chances. It requires some strategic planning, though.
Roth retirement accounts could spare you from Social Security taxes
If losing some of your Social Security income to taxes bothers you, one potential solution is to keep your retirement savings in a Roth account. The reason this works is that Roth plan withdrawals don’t count toward your AGI. As such, they won’t push you toward the thresholds where taxes on benefits come into play.
Here’s an example. Say you’re a single retiree who gets $4,000 a month, or $48,000 a year, in Social Security. Let’s imagine your only other retirement income source is a $3 million IRA that you withdraw $120,000 from per month.
If that $120,000 counted toward your AGI, you’d be pretty much guaranteed to pay taxes on your Social Security benefits. But in this case, the formula above — AGI + interest income + 50% of Social Security income — would only equal $24,000. That would put you right under the threshold where benefits are taxed.
Of course, this is a bit of a simplified example, since it doesn’t account for tax deductions and credits. The point, however, is that if you don’t want to pay taxes on Social Security, having savings in a Roth account is a good way to get out of it.
Do Roth conversions carefully
Now that you know how to potentially get out of paying taxes on Social Security, you can make an effort to save in a Roth IRA or 401(k). But if your income is too high for a Roth IRA, and/or if it doesn’t make sense for you to fund a Roth account because you’re in a higher tax bracket, there’s another solution — Roth conversions.
Once your income drops, you can move funds out of a traditional retirement account and into a Roth. But remember, Roth conversions count as taxable income. So you’ll need to time those carefully.
One thing you may want to do if you’re a higher earner is plan on Roth conversions if you’ll be scaling back on work in your late 50s or early 60s, before Social Security begins.
Let’s say you earn $300,000 a year now. You’re probably in too high a tax bracket to do Roth conversions.
If you semi-retire at 58 and your income falls to $100,000 a year, and you don’t claim Social Security until 67, you have a solid window to move funds into a Roth (though be careful as you get closer to 65, as a higher income could result in surcharges on your Medicare premiums).
Avoiding taxes on Social Security isn’t just a matter of having a low income in retirement. It’s a matter of being strategic. If you don’t like the idea of having your benefits taxed, lean on a Roth retirement account when you’re in the process of building wealth or plan on conversions when the opportunity presents itself.