Social Security retirees are staring at the course of one of the largest benefit increases in decades in decades in 2023. That’s because high inflation should translate into a high cost of living (COLA) adjustment to benefits to help retirees keep up with higher prices. However, that COLA increase could also cause retirees to pay more tax on their Social Security benefits if the increase pushes more of their combined income over certain thresholds.
Individuals with a combined income of more than $25,000 will have to pay taxes on as much as half of their Social Security benefits that exceed that threshold. Individuals with a combined income of more than $34,000 will have to pay taxes on as much as 85% of their benefits. For married couples, those numbers are $32,000 and $44,000, respectively.
With this in mind, retirees may want to think about ways they can lower their Social Security taxes. Fortunately, there are several ways to do this effectively. Here are five.
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1. Contribute to an IRA
As you get older and begin to approach the age at which you can qualify for Social Security, it may be wise to have multiple retirement accounts, such as an Individual Retirement Account (IRA) and a Roth IRA. You will probably have at least one as you get older.
The two accounts serve different purposes, but a traditional IRA can be useful because contributions are tax-deductible throughout the year and you can contribute up to $6,000 or $7,000, depending on your age. However, you must have earned income to make IRA contributions, so those who are not working would not be able to do so. If you are not enrolled in a workplace retirement plan, your contributions are 100% tax-deductible. If you’re covered, you can still contribute to an IRA and receive some amount of deduction.
This deduction can give you some flexibility as your combined income approaches a tax threshold. Consider if you have $27,000 in combined income and then can contribute $2,500 to an IRA. That puts your combined income below $25,000 and excludes your Social Security benefits from counting as taxable income.
2. Using a Roth IRA
Roth IRAs differ from traditional IRAs because you contribute to them with after-tax dollars and you don’t pay taxes on your earnings in the account. Furthermore, you can withdraw tax-free money from an IRA after 59 1/2 years.
These withdrawals also don’t count towards your combined income, which can be hugely beneficial as you approach a threshold. So if you can replace other sources of income with Roth IRA withdrawals in any given year, that’s one way to keep your taxable income lower.
In fact, it is possible to convert money from a traditional IRA to a Roth IRA to take advantage of the tax benefits of a Roth IRA later on. The amount you convert usually counts as taxable income, so keep in mind how that affects your current year’s income. It may also be beneficial to think about this before receiving Social Security benefits.
3. Donate IRA Distributions
While IRA contributions can be helpful, there are also some drawbacks. If you are enrolled in a workplace IRA plan, minimum benefits (RMD) will likely be required, requiring the retiree to withdraw a specified amount from the account by the time they reach age 72. These usually count towards your taxable income.
If an RMD pushes you over a certain threshold, it may be smart to donate this amount to charity, which can shrink your combined income. However, this strategy is only an option for people 70 1/2 years of age or older. If you qualify, you can contribute up to $100,000 to your IRA, which means that this income is not taxed.
4. Buy a QLAC
Another way to lower your RMDs is to purchase a Qualified Longevity Insurance Contract (QLAC). In an annuity, a retiree makes a lump sum payment up front, which comes back to them later through monthly distribution payments. It’s another way for retirees to prepare for the future as they get older and make sure they have enough income to support them.
QLACs must be a deferred income annuity, meaning that payments, made based on a person’s pre-tax IRA, cannot begin until at least one year after the contract is purchased, although they can be delayed much further into the future until age from 85
In a QLAC, retirees can take $145,000 or 25% of their IRA balance from what it was at the end of the previous year, whichever is smaller. That means you can take $145,000 if your IRA balance is $580,000 or more or 25% of your IRA if the balance is less than $580,000.
This effectively reduces the amount of money in your IRA, which is how the RMDs are calculated. So the fewer assets in your IRA, the smaller your RMDs will be, resulting in less combined income during the deferral period.
5. Harvesting Tax Losses
Harvesting tax losses can be used in any tax strategy, but should not be overlooked for reducing the amount of your Social Security benefits that are taxed as well. If you invest in stocks or bonds and have losses on your books, you can sell those positions at a loss, which then turns into a tax deduction.
The deduction is balanced against your other capital gains, which count toward your combined income. So if you have $4,000 in capital gains in a given year and then sell some assets for a $2,000 loss, that loss is subtracted from the $4,000, resulting in only $2,000 in capital gains. You never know, keeping you below a tax threshold can make all the difference.