Social Security probably plays an important role in your retirement plan. But did you know that you might have to pay federal income tax on your benefits?
Depending on your income, you could owe taxes on as much as 85 percent of your Social Security benefit. Here’s how to figure out whether taxes will reduce your payments, and if so by how much.
Assess your income
The key number to watch is your “combined income.” This figure includes:
- Your gross income
- Any tax-exempt interest you receive, such as from municipal bonds
- Half of your total Social Security benefit
If your combined annual income is less than the current threshold, you won’t have to pay any tax on your Social Security benefits. In 2013 that threshold is $25,000 for single filers and $32,000 for married couples.
If your combined income is between $25,000 and $34,000 (for single filers) or $32,000 and $44,000 (for couples filing jointly), things are a bit more complicated. At that level, up to half of your Social Security benefits may be subject to taxes.
And if your combined income exceeds $34,000 (single) or $44,000 (married filing jointly), you’ll owe federal income taxes on 85 percent of your Social Security benefits.
Staying under the threshold
Staying below the combined income threshold can help minimize your social security tax burden. The following strategies may help:
Monitor your municipal bonds. The federal government doesn’t tax interest on municipal bonds. However, that interest does count toward your combined income. If you’re near the combined income threshold, municipal bond interest might be enough to push you into a higher Social Security tax rate.
Develop a tax-sensitive withdrawal strategy. Be careful about how and when you make withdrawals from your retirement accounts, suggests Andy Landis, author of Social Security: The Inside Story. Withdrawals from tax-free accounts like Roth IRAs and Roth 401(k)s don’t count toward the combined income total. “But pulling from a traditional IRA or 401(k) is different,” he says. “You have to pay taxes on the money and it might push you over the income threshold, so your Social Security benefits get taxed, too. It can be a double whammy.”
So if you’re close to the threshold, you might prioritize withdrawals from Roth accounts, as well as other savings vehicles—like brokerage accounts—that won’t affect your combined income.
Consider withholding. You can withhold income taxes on Social Security benefits just as you would with a regular paycheck. This option is best for people who are confident that they’ll exceed the minimum combined income threshold. Having the tax automatically deducted means you’ll spread your tax payments across the entire year—potentially making April 15 less daunting.
Social Security taxes are just one of the many moving parts that can affect your income in retirement. A financial advisor can help you build a retirement income plan that considers all these factors so you can minimize the tax bite on your lifestyle.