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Here's how to reduce the taxes on your Social Security benefits

It goes without saying that death and taxes are two of life’s certainties.

But what many people don’t know is that their Social Security retirement benefits might be taxed.

And that means that they haven’t been using strategies proactively to reduce those levies and extend their income over their retirement years.

William Meyer, founder of Social Security Solutions, a provider of benefits-claiming software, estimates that, on average, you can find up to seven years’ worth of more money by creating tax-efficient withdrawal strategies that coordinate Social Security benefits.

And those savings can be as much as hundreds of thousands of dollars, according to Meyer.

“It adds up to a lot of money for most people,” Meyer said. “It doesn’t matter if you have a lot of money or a little.

“That savings can be substantial.”

How Social Security benefits are taxed

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Approximately 40% of people who receive Social Security benefits pay federal income taxes on that income, according to the Social Security Administration.

If your income is low enough, none of your Social Security income may be taxed. But there are two additional tax tiers, which means that either 50% or 85% of your benefits could be subject to federal tax.

In order to know where you fall, you need to know your “provisional,” or combined, income.

To calculate that, add your adjusted gross income plus non-taxable interest plus half of your Social Security benefits. Those values can be found on your 1040 tax form.

If you file as an individual, you are subject to taxes on up to 50% of your Social Security benefits if your combined income is between $25,000 and $34,000. But if you’re over $34,000 in combined income, up to 85% of your benefits are subject to income taxes.

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If you’re married and filing jointly, those thresholds for combined income are higher. You will be subject to taxes on up to 50% of your benefits if your income is between $32,000 and $44,000. That goes up to up to 85% of your benefits if your income is more than $44,000.

And if you’re married and filing separately, you could also pay taxes to the tune of up to 85% of your Social Security income. That’s what Joe Elsasser, president and CEO of Covisum, a Social Security claiming software company, calls a “gotcha” for those taxpayers.

Many people find out whether they owe federal income taxes on their Social Security income at tax time when they tally their Social Security benefit statement and other income.

Of note, you may also face state taxes on your Social Security income, depending on where you live. Most states do not impose levies on these benefits. But 13 states do, though the rules for that vary from state to state. Those states are Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont and West Virginia.

Why you want to avoid a tax torpedo

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If you’re just now adding up your income for your April returns, it’s too late to mitigate those Social Security taxes.

But it’s not too late to try to bring down the rate at which you will be taxed on your benefits income for the next tax year.

What you most want to watch out for is something called the “tax torpedo.”

A tax torpedo occurs when there is a sharp rise and fall in marginal tax rates due to the taxation of Social Security benefits. Marginal tax rates are the extra taxes you pay on each additional dollar of income.

For example, a hypothetical single retiree receiving $30,000 per year in Social Security benefits, in addition to other income, could have a marginal tax rate of 0% if their modified adjusted gross income is up to $12,400, according to research published by Meyer.

What you’re really looking to do is change the blend of income that you have in order to actually save tax dollars rather than just prepay them.

Joe Elsasser

president and CEO of Covisum

But that could climb to 15% for income between $12,400 and $18,750; 18% on $18,750 to $19,000; 22.2% on $19,000 to $34,568; and then up to 40.7% on income between $34,568 and $43,706. Beyond $43,706, the marginal tax rate could drop down to 22%.

Meanwhile, how much of their Social Security benefits are taxed also climbs with those thresholds, until 85% of the Social Security benefits are taxable at modified adjusted gross income of $43,706.

But there are strategies to prevent those tax rates from climbing so high. Waiting to claim Social Security benefits for as long as possible — up until age 70 — is one, according to Meyer. That’s because that could help to increase Social Security income while decreasing the amount of money you take from tax-deferred retirement accounts such as 401(k) plans.

The other strategy is to adjust the sources from which you take your income.

One area to watch is how withdrawing extra money from an individual retirement account can increase your tax bill.

If you’re at a 12% tax bracket and take an extra $1,000 out of your IRA, you could consequently lose almost $500 to federal income taxes due to an “ugly interaction” between Social Security, ordinary income and capital gains, Elsasser said. “That shocks a lot of people,” Elsasser said.

To mitigate that, it helps to be mindful about how your decisions could trigger higher taxes.

“What you’re really looking to do is change the blend of income that you have in order to actually save tax dollars rather than just prepay them,” Elsasser said.

To help keep capital gains down, you could opt to use more tax-efficient investments such as exchange-traded funds instead of mutual funds, Elsasser suggested. Investment-only variable annuities could let you defer taxes until you take withdrawals, he said. The risk is that that can, however, increase your ordinary income.

You may also look for losses to offset gains in a portfolio, Elsasser said.

You may also want to tap non-taxable accounts, such as a Roth 401(k) or Roth IRA, that will not count as ordinary income, Meyer said.

Even if you think you’re already at that highest 85% level for Social Security taxes, there are likely still strategic moves you can make, Meyer said.

“Be very strategic about your withdrawal strategy,” Meyer said. “You might be able to draw down in a sequence that keeps less of your Social Security taxed.”

For help, the best source to consult is a competent financial advisor who is able to offer advice on both retirement income and taxes, he said.

Source: Investing - personal finance - cnbc.com

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