How to Reduce (or Avoid!) Taxes on Social Security Benefits

For most retirees, Social Security is an essential component of retirement income planning. Yet retirement income planning is only complete once you’ve considered taxes too. Thank­fully, strategic tax planning can help minimize—and sometimes even avoid—the taxes you pay on Social Security benefits.

Let’s start with under­standing how benefits are taxed. As a retiree, the taxable portion of your benefits depends on your filing status and other income (pensions, wages, taxable and nontaxable interest, dividends, and capital gains).

Single filers, you have taxable benefits if your total income is:

• Between $25,000 and $34,000: you may have to pay income tax on up to 50% of your benefits.
• More than $34,000: up to 85% of your benefits may be taxable.

Joint filers, you have taxable benefits when your combined income is:

• Between $32,000 and $44,000: you may have to pay income tax on up to 50% of your benefits.
• More than $44,000: up to 85% of your benefits may be taxable.

Now let’s look at several retirement tax-planning techniques you can consider for minimizing these taxes. The best options will of course depend on your situation.

1. Follow a tax-efficient withdrawal sequence for annual income.
   Our New Three-Legged Stool strategy is designed to help retirees reduce their tax bill by drawing income from three types of accounts (tax-deferred, tax-free, and after-tax) in a tax-efficient manner. One study found the most tax-efficient withdrawal sequence could extend a retirement portfolio by seven and a half years longer than the least tax-efficient sequence.¹
   
   
2. Plan for smaller Required Minimum Distri­b­u­tions (RMDs).
   After age 73, one of the largest gener­ators of taxable income for retirees is their RMDs from tradi­tional IRAs, 401(k)s, and other tradi­tional retirement accounts. During the years before age 73, look for oppor­tu­nities to withdraw from tax-deferred accounts during low-income years.
   
   
3. Build up a Roth IRA.
   Take advantage of the oppor­tunity to contribute to Roth accounts any year you have earned income. Roth accounts are an essential part of the New Three-Legged Stool and provide flexi­bility as you determine which accounts to pull income from each year. Roth IRAs are not subject to RMDs, which we mentioned are one of the major sources of taxable income for retirees. Beginning in 2024, this will also apply to desig­nated Roth accounts in 401(k)s and other qualified plans.
   
   You can also consider doing Roth conver­sions in the years before you claim Social Security benefits. Ideally, a Roth conversion will fall in a year when income is low. For some, these years might be after ending employment but before beginning to collect Social Security. Through this strategy, the tax-deferred funds you convert to a Roth IRA will no longer be subject to RMDs and the associated taxes. Additionally, you’ll be able to withdraw the converted money tax-free once the five-year rule and other require­ments are satisfied.
   
   
4. Give to favorite causes through Qualified Chari­table Distri­b­u­tions (QCDs).
   QCDs from a tradi­tional IRA are available to those at least age 70 ½. If you’re chari­tably minded, you could transfer up to $100,000 annually from a tradi­tional IRA to a qualified charity or nonprofit. There are no chari­table deduc­tions available with QCDs, however the withdrawals are not taxed. Any QCDs you take before age 73 will help reduce your amount of future RMDs and the taxes associated with them. At age 73 and above, you can use QCDs to satisfy some or all of your RMD requirements.
   
   
5. Harvest tax losses during the year.
   The federal tax code says that capital losses can be used to offset capital gains. If your losses exceed your gains, you can take up to a $3,000 loss against other income. An unrealized loss occurs when a security has decreased in value from your purchase price. In itself, an unrealized loss does not have a tax benefit and is not tax deductible. To use the loss, you have to sell the security, at which point the loss is realized and becomes deductible for tax purposes.

Other Reasons to Keep Taxable Income Low

Social Security isn’t the only federal program in which higher-income partic­i­pants face additional costs. Medicare is similar. Premiums are means-tested through Medicare’s income-related monthly adjustment amount (IRMAA) program, which was estab­lished in 2003.

That means if you keep your Modified Adjusted Gross Income (MAGI) lower, your monthly Medicare premium may be lower as well. Individuals who reported MAGI under $103,000 and married couples filing jointly who reported MAGIs under $206,000 (for 2022) are paying the current Medicare Part B basic premium of $174.70 per month. Those with higher MAGIs pay an IRMAA surcharge on Part B and Part D (which can bring premiums to $594 per month). You can consider using the same strategies to minimize Medicare premiums as we discussed for minimizing taxation of Social Security benefits.

Final Thoughts

The income threshold for the taxation of Social Security is relatively low. The thresholds have stayed the same since the 1990s and aren’t expected to change, consid­ering the forecasts for the Social Security Trust Funds. Keeping your income below these thresholds may only work if you start building your New Three-Legged Stool early. Fortu­nately, planning strategies like the ones we’ve discussed can help you manage your retirement tax liability and possibly extend the life of your nest egg.

Insights:

• The taxable portion of Social Security benefits depends on the retiree’s filing status and other income.
• A tax-efficient withdrawal sequence could extend a retirement portfolio consid­erably longer than an ineffi­cient sequence.
• Similar to Social Security, Medicare premiums are means-tested and adjusted based on monthly income. Retirees can consider the same strategies for reducing Medicare premiums as for minimizing taxation of Social Security benefits.