Strategies to Manage the Taxation of Social Security

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Strategies to Manage the Taxation of Social Security Last week I talked about the double taxation of dividends. Corporations pay tax on their earnings which are taxed a second time when they are distributed to the shareholder as dividends. The Jobs and Growth Tax Relief Reconciliation Act of 2003 was an attempt by Congress at minimizing the tax bite by allowing dividends to be taxed at a lower tax rate. But dividends are not the only income that is taxed twice, as millions of retirees who are drawing Social Security benefits have found out. Retirees with provisional income below the base amounts of $25,000 (single filer) and $32,000 (joint filer) are not subject to federal personal income tax on their Social Security benefits. Retirees with income above these thresholds will find that the tax applies to some percentage of their benefits. For joint filers with incomes above an “adjusted base amount” of $44,000, up to 85% of benefits can be taxed.

Congress passed a series of amendments to Social Security in 1983 that were designed to stabilize the system. Under the ’83 Amendments, up to one-half of the value of the Social Security benefit was made potentially taxable income. Social Security benefits are funded by taxes and those benefits were not intended to be treated as ordinary income. The amount withheld from your paycheck for “FICA” is pretax and not deductible. FICA is short for Federal Insurance Contributions Act. Taxpayers are paying for old age, survivor, and disability insurance through Social Security, at 6.2% of earned income, up to a maximum $110,100 in 2012. Their employer also matches the amount withheld from the employee.

When Congress first started taxing Social Security benefits only 50% were subject to tax. The argument was that they were taxing the employer’s contribution which the employer deducted as a business expense and the employee never paid taxes on. The Omnibus Budget Reconciliation Act of 1993 raised the taxable amount of Social Security to 85% and the double taxation began.

The current system potentially taxes seniors twice on the same income. First, when the income is earned and the FICA tax is withheld. The second time the same income is taxed is when it is paid back as Social Security benefits and total income exceeds the adjusted base amount. Incidentally, adjusted refers to certain deductions that are permitted when calculating the amount of Social Security benefits subject to tax. The threshold amounts are not adjusted for inflation like most brackets in the tax code. The $44,000 base amount has not changed in the nearly 20 years since it became law.

Knowing how Social Security benefits are taxed helps when devising strategies to minimize the taxation of those benefits. Here are a couple of strategies we use to minimize the tax on benefits:

Change Investment Income – Investments like Certificates of Deposits (CDs), Government and/or Corporate Bonds, Preferred stocks and income mutual funds are typically used to produce retirement income. All the income produced by these types of investment vehicles will be included in the calculation to determine if Social Security benefits are 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.

Instead of investing all the money in income investments, invest a portion in an income annuity that makes monthly payments of principal and interest. Only the interest portion will count towards taxation of benefits. The balance should be invested in a growth vehicle like a tax-managed growth mutual fund that produces little taxable income. The growth fund should replace the principal paid down as the income annuity is depleted to zero. The exciting result of this strategy is what has happened to the taxation of Social Security benefits. Only the interest portion of the annuity payments and the small dividends from the growth fund are used to determine if Social Security benefits are taxed. Some taxpayers may be able to keep all of their Social Security benefits.

A similar 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 strategy would be riskier than using an immediate income annuity because mutual funds are not guaranteed. 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. 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.

Rick’s Insights

  • Social Security benefits may be subject to income taxes depending on your total income.
  • The income threshold at which Social Security benefits becomes taxable is not adjusted for inflation.
  • Careful tax planning can minimize the amount of Social Security benefits subject to tax.

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