facebook twitter instagram linkedin google youtube vimeo tumblr yelp rss email podcast phone blog external search brokercheck brokercheck Play Pause
How Pre-Retirees Can Manage Tax Implications of Social Security Thumbnail

How Pre-Retirees Can Manage Tax Implications of Social Security

Social Security benefits can be a major income source in retirement, but for pre-retirees, planning how these benefits fit into an overall financial strategy can be challenging. The way you structure your income sources in retirement can greatly impact how much of your Social Security is taxed. Here’s a guide on managing the tax implications of Social Security benefits as you approach retirement.

1. Understand How Social Security is Taxed

Unlike other income sources, Social Security benefits are subject to a unique tax formula. The IRS uses a formula called "combined income" or "provisional income" to determine if your Social Security benefits will be taxed. Combined income includes your adjusted gross income (AGI), tax-exempt interest, and half of your Social Security benefits. Based on this calculation, the following rules apply:

  • If your combined income is below $25,000 (for single filers) or $32,000 (for married filers), none of your Social Security benefits are taxable.
  • If combined income is between $25,000 and $34,000 (single) or between $32,000 and $44,000 (married), up to 50% of your Social Security benefits may be taxable.
  • If combined income exceeds $34,000 (single) or $44,000 (married), up to 85% of your benefits may be taxable.

Understanding where you fall within these thresholds can help you better manage your taxable income in retirement.

2. Delay Social Security Benefits for a Tax Break

Delaying your Social Security benefits not only increases the monthly benefit amount but can also reduce your taxable income during the early years of retirement. By waiting until full retirement age or even until age 70, you can take advantage of deferring Social Security while relying on other income sources, such as IRAs or brokerage accounts, which may allow you to stay below the taxable income threshold.

This strategy can help pre-retirees avoid having Social Security benefits taxed at higher rates in the early retirement years, providing flexibility to control how and when income is taxed.

3. Strategically Withdraw from Retirement Accounts

To control how much of your Social Security is taxable, consider where your income is coming from in retirement. Traditional IRA and 401(k) withdrawals are considered taxable income, and these distributions add to your combined income. To minimize this impact:

  • Consider Roth accounts for retirement savings, as Roth IRA withdrawals do not count as income for Social Security tax purposes.
  • Strategically withdraw from a combination of taxable and tax-free accounts. For example, you could supplement income with Roth distributions to avoid pushing your combined income into a higher tax bracket for Social Security purposes.

This income-blending approach can reduce your tax burden on Social Security.

4. Manage Required Minimum Distributions (RMDs)

Once you reach age 73, you’ll be required to start taking RMDs from traditional IRAs and 401(k)s, which can impact your Social Security tax rate. Planning ahead by converting some of your traditional retirement funds to Roth accounts before reaching RMD age can help reduce future RMDs, thus lowering your taxable income later in retirement. Roth conversions in pre-retirement years may incur taxes upfront, but they can lead to greater tax flexibility down the line.

5. Watch Out for Additional Medicare Surcharges

Taxable Social Security benefits and other retirement income can also trigger surcharges on Medicare premiums, known as IRMAA (Income-Related Monthly Adjustment Amount). Staying below certain income thresholds can help you avoid IRMAA, which is an added cost on top of Medicare Part B and Part D premiums. By managing the timing and sources of income, you can potentially reduce both your Social Security tax and Medicare premiums.

Key Takeaway: As you approach retirement, careful planning around Social Security benefits, Roth conversions, and income sources can help you minimize taxes on Social Security benefits. By understanding how the tax rules apply and making proactive adjustments, you can maximize your income and reduce your tax liabilities in retirement.