Last week we looked at when to draw Social Security benefits. This week we will discuss strategies to minimize the taxation of those benefits. The amount of taxes a worker pays into the Social Security system is not deductible from their federal income tax return unlike state and local income taxes. Originally, the benefits received by retired workers were not taxed because it was reasoned that the money had already been taxed. Legislation was passed in 1984 that was designed to keep Social Security solvent. Most workers have half of their Social Security taxes paid by their employer. It was now determined that the half paid by the employer was not taxed. So benefits began being taxed for retired workers with incomes over $25,000 filing as single, or with combined incomes over $32,000 (if married filing jointly). The whole idea of some of the taxes being paid by the employer was thrown out in 1994 when the portion of benefits potentially subject to tax was increased to 85%.Knowing how Social Security benefits are taxed helps us when devising strategies to minimize the taxation of those benefits. The formula begins by looking at your total income. This includes nearly everything — interest and dividend income including tax-free municipal bond income, taxable pensions, other investment income, wages, net income from rental properties, farm income, and IRA distributions. What you can exclude is interest income from U.S. savings bonds, excludable foreign-earned income, and tax-free distributions from a Roth IRA.The government does allow some deductions from your total income. You can subtract losses on investments (up to $3,000), losses from rental properties, business losses, and farm income losses. This would actually be part of the first step to determine total income. The other allowable losses are at the bottom of page one on IRS form 1040 – contributions to IRA or SEP IRA, Health Savings Account deduction, tuition and fees, self-employed health insurance, etc. Based on this formula, up to 85% of your benefits can be taxed. Now let’s look at strategies to reduce this tax.
Changing Investment Income — Most people structure their investments to produce income in retirement for obvious reasons. They are no longer working and now rely on their investment income to meet daily living expenses. It seems obvious that it makes sense to attempt to maximize the yield on investments to produce the highest income. Investments like Certificates of Deposits (CDs), Government and/or Corporate Bonds, Preferred stocks and income mutual funds are typically used as the investments of choice. This approach may make investment sense but it doesn’t make tax sense especially when drawing Social Security. All the income produced by these investment vehicles will be used to make more of your SS benefits taxable. Income from municipal bonds and tax- free mutual funds are used to determine the taxable amount of your benefit even though the interest from these investments is not taxable.
A similar but more tax efficient result can be achieved by investing in growth oriented mutual funds and taking systematic withdrawals. Part of each withdrawal will be considered a return of principal and the rest will be taxed as earnings. This would be riskier than using an immediate annuity because mutual funds are not guaranteed, but the tax on the investment earnings would be lower because once you’ve held the fund for 1‑year the distributions would be considered long-term capital gains which currently have a lower rate of tax than annuity income.
IRA Distributions — After you reach age 70 ½, you must begin taking minimum distributions from your IRA account. Those distributions are considered income to be used in determining the taxability of your benefits.
Most people will use the Uniform Lifetime Table to determine their minimum distribution. It is the most commonly used of three life-expectancy charts that help retirement account holders figure mandatory distributions. The other tables are for beneficiaries of retirement funds and account holders who have much younger spouses. If you have an IRA balance of $100,000 at the end of the year before your 70 ½ birthday, you will need to withdrawal $3,650 according to this table. Each year the withdrawals should increase as you get older and the account continues to growth because you are only taking out the minimum amount. If your income falls near the base amounts, these minimum distributions could prove costly from the taxation of your Social Security benefits. Minimum distributions could be avoided by converting your IRA to a Roth IRA all in one year. This would result in a large tax bill the year of the conversion but you may avoid a lot of additional tax on your benefits in future years.
Additional steps you can take to reduce the tax on your Social Security benefit:
- Make deductible IRA contributions if you have wages and are under age 70½. If you have self-employment income, make SEP or SIMPLE contributions to reduce your income.
- Use tax-managed mutual funds or passively managed funds that are more tax efficient in your taxable accounts. Actively managed mutual funds that are not specifically tax managed must distribute realized capital gains at the end of the year. The distributions are included as income in the calculation and can negate your efforts to minimize the tax on your benefits.
- Harvest unrealized losses at year end. Remember you can take a maximum net loss from investments of $3,000 on your tax return. This loss can also be used in the benefit calculation to reduce income.
The New Three-Legged Stool™ strategy for retirement planning was developed to provide flexibility in your retirement income to minimize income taxes. This strategy is especially effective when minimizing the amount of Social Security benefits that will be subject to tax. Distributions from a Roth IRA are not used in the formula for calculating the tax on those benefits. Saving in a Roth IRA is the third leg of the New Three-Legged Stool™.
- Understanding how your Social Security benefits become taxable is the first
step to developing a strategy to reduce the tax.
- Not all types of income contribute to the taxation formula. Change your
income to exclude some or all of the income used.
- Saving for retirement using the New Three-Legged Stool™ approach will help
minimize the amount of Social Security benefits subject to tax.