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Will your Social Security benefits be hit with a tax torpedo?

by Susan Wright | Contributor
December 1, 2020

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If you are eligible for Social Security retirement benefits, this income might make up a significant portion of your incoming cash flow in the future. According to the Social Security Administration, an average wage earner could replace roughly 40% of their pre-retirement earnings with this benefit alone.

But even so, you may not necessarily be able to spend the full amount of the benefit you receive from Social Security. That’s because up to 85% of this income could be taxable – and these taxes can reduce the amount of money you have for paying your living expenses and other financial obligations.

One of the best ways to avoid taxation of your Social Security retirement benefits is to have a good understanding of how and when these taxes are incurred. That way, you can coordinate any other income sources that you have for lowering your tax obligation, or possibly even eliminating it altogether.

Is Social Security retirement income taxable?

In some cases, the retirement income that is received from Social Security can be subject to income taxes. It is estimated that approximately 16% of Social Security income recipients pay tax on up to 50% of these benefits.

Many people are unaware that their Social Security may be taxable until they have reached retirement. Unfortunately, though, it could be too late to do anything about it at that time. So, knowing why this income could be subject to taxation – as well as how much – can allow you to put some viable strategies in place for reducing Uncle Sam’s “portion” of your Social Security benefits.

What can cause your Social Security benefits to become taxed?

Many retirees receive income from more than just one source. But, while this can provide you with a higher dollar amount of incoming cash flow, you could also incur a higher income tax liability, in turn, putting less net spendable income in your pocket.

Social Security income recipients can be subject to federal income tax if they have “other substantial income in addition to these benefits.” In this case, there are actually several ways that you could become caught in the Social Security “tax trap.” These can include:

  • Taking withdrawals from traditional IRAs and/or 401(k) plans
  • Earning wages from a job (while also receiving Social Security retirement income)
  • Receiving income and/or dividends from investments
  • Generating self-employment income

How much tax will you pay on your Social Security retirement income benefits?

Depending on how much other income you earn, as well as the way you file your income tax return (such as individual or joint with a spouse), you may be required to pay tax on up to 85% of your Social Security benefits.

Social Security determines the amount of your “combined” income by using the following formula:

Your Adjusted Gross Income

+

Non-taxable Interest

+

Half of your Social Security Benefits

=

Combined Income

Every year in January, the Social Security Administration generates a benefit statement for retirement income recipients that provides information on the amount of income that was received from this source during the previous year. Based on that amount, you can determine how much – if any – of your benefits will be subject to income tax.

Is there a way to reduce or eliminate income tax on your Social Security?

The good news is that there are some financial strategies you could put in place to reduce, or even to eliminate, taxes due on Social Security income. These could include:

  • Keeping your total combined income below the thresholds
  • Receiving traditional IRA withdrawals before filing for Social Security benefits
  • Taking advantage of the Roth IRA

Certainly, one method for keeping your Social Security benefit tax low (or even non-existent) is to make sure that your total combined income falls below the thresholds. For instance, if you file your tax return as an individual (in 2020), generating less than $25,000 from other sources can keep your benefits in check.

Another option is to receive any income from traditional IRAs (Individual Retirement Accounts) and/or traditional 401(k)s (or other taxable employer-sponsored sources) prior to filing for your Social Security benefits.

In this case, income and withdrawals from traditional accounts are oftentimes 100% taxable. That is because the contributions are usually pre-tax, and the gains are tax-deferred – and because none of these dollars have been taxed in the past, they will be hit with tax when they are received.

Taking advantage of a Roth IRA can also be a good way to sidestep tax on your Social Security benefits. Roth IRA contributions go in after-tax, and the gains that take place in the account are tax-free. The income and withdrawals from Roth IRAs are also free from income taxes.

Therefore, these funds are not considered income by the Social Security Administration, nor will they be considered in the calculation for your combined income. Prior to opening a Roth IRA, though, make sure that your income does not exceed the maximum limit.

In this case, individual tax filers must earn less than $139,000 for the tax year 2020, and those who file their federal income tax jointly with their spouse may not open a Roth IRA if income exceeds $206,000. However, even if your income is more than these amounts, an experienced financial professional can assist you with other methods for still taking advantage of the Roth IRA.

What is the next best step for maximizing your Social Security retirement benefits?

Generating as much income as possible in retirement might not actually put the highest amount of spendable income in your pocket. So, it is essential that you have a good, solid strategy in place for reaping the most for yourself instead of Uncle Sam.

Alliance America can help

Alliance America is an insurance and financial services company. Our financial professionals can assist you in maximizing your retirement resources and achieving your future goals. We have access to an array of products and services, all focused on helping you enjoy the retirement lifestyle you want and deserve. You can request a no-cost, no-obligation consultation by calling (833) 219-6884 today.

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