How to Minimize Taxes on Social Security Benefits

Oct 9

How to minimize Social Security Taxes financial advisor ridgewood nj poughkeepsie ny CFP Independent RIA Vision Retirement fiduciary advisor.

According to the Social Security Administration, an average of 67 million Americans are currently receiving a Social Security check each month (in 2023): with these benefits comprising 40% of income for approximately 40% of recipients ages 65 and older. For 14% of this group, Social Security represents 90% of their income.

Regardless of wherever you fall on this spectrum, the point is that every dollar counts—especially during retirement. In this post, we’ll share a few tips on how to get the most out of your Social Security check moving forward.

How Social Security benefits are taxed

Your Social Security benefits are liable to federal taxes depending on the earnings listed on your income tax return. If your combined income is more than $25,000 (for an individual) or $32,000 (for a married couple filing jointly) in 2023, you must pay taxes on your Social Security income (yes, we acknowledge these thresholds are very low).

The Social Security Administration considers the sum of your adjusted gross income, nontaxable interest, and half of your Social Security income “combined income.”

The amount of your benefits subject to taxation, meanwhile, varies based on income level. For example, if you’re a single filer and your combined income falls between $25,000 and $34,000, up to 50% of your benefit amount is taxable. This number rises to 85% if your combined income exceeds $34,000.

For married joint filers whose combined income falls between $32,000 and $44,000, 50% of the benefit is taxable and rises to 85% for combined income over $44,000.

Keep in mind that if you reside in Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, Rhode Island, Utah, or Vermont, your Social Security income will also get taxed at the state level to varying degrees.

With this background in mind, let’s discuss some strategies to minimize (or even avoid!) paying taxes on your Social Security benefits.

Anticipate IRA RMDs

RMDs are the minimum amount of money one must withdraw from specific tax-deferred retirement accounts beginning at age 73 (starting in 2033, this stipulation will climb to age 75).

More specifically, RMD rules apply to various employer-sponsored retirement plans including 401(k), 403(b), profit sharing, and 457(b) plans as well as traditional IRAs and IRA-based plans such as SEPs, SARSEPs, SIMPLE IRAs, and Roth IRAs (following the owner’s death).

Those impacted are required to take their RMDs by December 31 of each year. However, a couple of options are available with respect to your first one. For example, if you turn 73 in 2023, you can take your first RMD by either December 31, 2023 or April 1, 2024. Keep in mind that no matter which option you choose, you’ll need to take your second RMD by December 31, 2024.

While you may rely on RMDs for various expenses, taking distributions could push you into a higher income tax bracket: meaning more of your Social Security benefits are subject to taxation. As a result, you can consider drawing down your IRAs before claiming your Social Security benefits to help minimize Social Security taxes—taking penalty-free distributions after age 59 1/2. If you don’t need this money, you’re likely well over the Social Security income tax threshold; but know you can also donate your RMDs to charity (up to $100,000 annually) through a qualified charitable distribution (QCD).

Consider a Roth IRA conversion

A Roth IRA conversion is the process of rolling over all (or a portion) of your balances from either an existing traditional IRA, SEP, or SIMPLE IRA into a Roth IRA.

One of the most common reasons to convert a traditional IRA into a Roth IRA is the ability to enjoy tax-free withdrawals in retirement. Unlike a traditional IRA—whereby you must pay taxes on investment gains and any tax-deductible contributions—Roth IRA withdrawals are tax-free, provided you meet specific requirements.

Another common reason why investors choose a Roth IRA conversion is to avoid required minimum distributions. Unlike its IRA counterpart, a Roth IRA isn’t subject to any RMD rules: meaning you won’t need to make any withdrawals at any point during your lifetime. As a result, the money in a Roth IRA account can remain in the account and continue to grow tax-free.

As with any investment, Roth IRA conversions aren’t for everyone—typically due to the prospect of high tax bills, as you’d need to pay taxes on the amount you convert.

Delay Social Security benefits

For many, this option is easier said than done—especially if you’ll depend on Social Security as your primary source of income. However, delaying your claim not only reduces the number of years your benefits are subject to tax but also means you’ll leave less money on the table when all is said and done: because while you can collect benefits as early as age 62, you’ll receive a more robust amount (about 7% higher) each year you wait until reaching your full retirement age (when you first become entitled to your full Social Security benefits). If you wait even longer, the increase rises to approximately 8% each year between your full retirement age and age 70.

To illustrate, let’s assume your full monthly Social Security benefit is $2,000: the amount you’d receive if you wait until your full retirement age. If you claim benefits at age 62, your benefit will be approximately 30% lower: or $1,400. As you can see, collecting too early means you could miss out on thousands of dollars a year that can help cover retirement-related expenses such as housing and healthcare.

If you’ve already started claiming benefits, reached full retirement age, and are under 70 years old, you can also suspend your retirement benefits to earn a higher amount. In this scenario, you aren’t forced to repay any of your benefits and your benefit will earn credits of approximately 8% per year: resulting in a higher monthly payment. You can reinstate benefit payments at any point until the month you turn 70, which is when they’ll automatically kick in again if you don’t take any action. Keep in mind, however, that suspending your benefit also does the same for any beneficiaries who currently receive checks based on your work history.

Take a deep dive into your investments

The goal here is to shift some of your investments so they won’t trigger taxes on Social Security benefits. Therefore, loading up on income-generating assets—such as dividend-paying stocks, most bonds, and real estate investment trusts (REITs)—will likely only amplify the tax hit on your Social Security benefits.

As an alternative idea, you can utilize a tax-loss harvesting strategy to help lower your tax bill. To do so, you would sell an investment that’s underperforming/losing money and then use that loss to potentially write off up to $3,000 in ordinary income (income other than long-term gains). You’d then reinvest the money from the sale into a different security that better meets your needs.

You can also add growth stocks to your investment portfolio to lower your taxable Social Security amount, as selling these only generates capital gains taxes that don’t count towards the earnings limit. What’s more, those gains are taxed at a more favorable rate than your ordinary income.

When it comes to bonds, meanwhile, interest income is often subject to tax (with the exception of most municipal bonds). However, keep in mind that interest income from municipal bonds is added back as part of your modified adjusted gross income when calculating potential taxes due on your Social Security benefits. A financial advisor can review your investment portfolio and help you make any necessary adjustments to reach your objectives in this respect.

In sum: how to minimize Social Security taxes

As you can see, avoiding taxes on your Social Security benefits is a challenging proposition—especially when you consider just how low these income tax thresholds are. For many soon-to-be retirees, a better approach is to evaluate your tax situation from a holistic perspective and then determine whether paying taxes on your Social Security benefits is even worth your worry.