You worked hard all your life, paying into the Social Security system. Now you're ready for payback time. Not so fast. Uncle Sam may want a piece of your benefits. Up to 85% of Social Security benefits may be subject to federal tax, but tax planning can help ease the pain.
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The tax hit will depend on your income and marital status. First figure your modified adjusted gross income, which includes non-Social Security sources of taxable income, such as pensions, wages, interest and dividends. Add in tax-exempt interest and certain other exclusions from income. Itemized deductions won't help you in this calculation, says Robert Seltzer, a certified public accountant in Beverly Hills, Cal.
Next add one-half of the Social Security benefits you receive for the year — the total is your "provisional income." Then look at the IRS's "base amounts" for taxing Social Security. The base amounts are $32,000 for married couples filing jointly and $25,000 for single filers.
If your provisional income exceeds the base amount, you will pay federal tax on your benefits. That's the case for many retirees who have investment income, a pension or rental income.
The percentage of benefits that are taxed depends on your income. Up to 50% of benefits are taxable when provisional income is between $32,000 and $44,000 for married couples filing jointly (for single filers, it's between $25,000 and $34,000). If provisional income is more than $44,000 (for singles, $34,000), up to 85% of Social Security benefits are taxable.
Say you're married filing jointly and your $42,000 in provisional income includes half of your $12,000 in Social Security benefits. Your provisional income exceeds the $32,000 base amount by $10,000.
The amount of benefits that will be included in your taxable income is either half your benefits ($6,000) or half the excess income over the base amount ($5,000) — whichever is smaller. In this case, you'll include $5,000 of benefits in your taxable income. At a 15% tax rate, the tax on benefits would be $750.
Worksheets in IRS Publication 915, Social Security and Equivalent Railroad Retirement Benefits, will help you compute the tax. Check with your state's tax department to find out if your state taxes your benefits.
Strategies to Lessen the Tax Hit
To lower the tax, you have to reduce your overall taxable income. "If you're above the thresholds, you need to look at the components of your AGI," says Donald Pinkleton, a certified public accountant in Richmond.
Those who are on the borderline of the 50% and 85% thresholds can most easily make tax-saving moves. "Rule No. 1 is try to avoid spikes and bumps in income," says Pinkleton. If you've been under the 85% threshold, a hefty profit from a stock sale could boost your taxable income for the year. You might consider accelerating income into one tax year or pushing off income to another year. Another way to reduce taxable income: Boost pretax IRA and 401(k) contributions.
Thomas McCabe, a certified public accountant with Prestige Wealth Management Group, in Flemington, N.J., says paying off a mortgage with cash savings could preserve benefits from tax. Say a beneficiary has a mortgage and savings throwing off taxable interest. The mortgage interest deduction won't reduce the beneficiary's modified adjusted gross income. But using the cash to pay off the mortgage will lower taxable income in the benefit taxation calculation, McCabe says.
In the year you convert a traditional IRA to a Roth, your benefits will likely get taxed because a conversion adds to your taxable income. You might consider doing smaller conversions over several years in amounts that take you to the top of your current tax bracket.
Taking the one-time tax hit could be worth it. Withdrawals from a traditional IRA and 401(k) are counted as taxable income. By converting, you may eliminate or reduce the tax hit on future benefits. "Roth income is not counted in the Social Security taxation calculation," says Larry Rosenthal, president of Financial Planning Services, in Manassas, Va.