7 Ways to Avoid Taxes on Social Security Benefits
With more than ten thousand people turning sixty-five every day it is not surprising that there is a lot discussion about strategies to maximize social security benefit payments. Equally important, however, is consideration of what your after-tax post-retirement income will look like. It doesn’t do much good to increase your social security benefits by $3,000 a year if the government is going to take it all back in income tax.
With annual benefits only averaging around $15,000 it is understandable that many seniors seek to supplement their social security with investment income or by drawing from retirement savings. For low income taxpayers social security income is not taxable at the federal level, however, when social security is combined with income from other sources it can result in taxation of a portion of your social security benefits. The key to maximizing after-tax retirement income is to find ways to reduce your provisional income.
Provisional income is a concept that is unique to social security. It is determined by adding one-half of your social security income to your modified adjusted gross income (MAGI). MAGI includes income from all sources, including tax-exempt interest, less social security payments. If your provisional income is less than the “base” amount, then your Social Security benefits are not taxable at all.
|Married Filing Jointly||$32,000||$44,000|
|Married Filing Separate||-||-|
If your income falls between the base and the adjusted amounts, you may have to pay tax on fifty percent of your benefits. When you exceed the adjusted amount up to 85 percent of your benefits may be taxed. No one pays tax on more than 85 percent of their social security benefits.
The following suggestions present a few ways I have seen retirees reduce or eliminate taxation of their social security benefits. As with all tax reduction strategies it is important to make sure that you are making sound financial decisions first and let the tax benefits be the icing on the cake.
#1: Apply for Social Security Early
Because one-half of social security income is included in the computation of provisional income, in some cases it can be beneficial to apply for social security early. This will reduce your annual benefits, but spreading your payments over a longer period of time can help improve the after-tax benefit received through the course of retirement.
#2: Convert your Traditional IRA to a Roth IRA
Since 2010 anyone has been permitted to convert their traditional IRA into a Roth IRA. Prior to that, only individuals with adjusted gross income under $100,000 were permitted to make this conversion. You will take a one-time tax hit on the conversion, but your savings will continue to grow tax free. Assuming you are over age 59½, once converted you can withdraw the converted amounts at any time. You must, however, let the Roth age for five years before withdrawing any earnings. After five years all withdrawals are made penalty and tax free. These Roth distributions are not considered taxable income for purposes of computing provisional income. So, unlike distributions taken from a traditional IRA these distributions will not contribute to the taxation of your social security benefits.
#3: Tax Deferred Annuities
With an annuity contract your retirement savings can continue to accumulate tax free and you don’t pay taxes, or include the income in the provisional income computation, until the earnings are distributed. Annuities come in two flavors – qualified and non-qualified. Both allow for tax-free accumulation of earnings. Qualified annuities, like traditional IRAs, are funded with pre-tax dollars, so withdrawals are fully taxable. Non-qualified annuities, on the other hand, are funded with after-tax dollars, so only the earnings are subject to taxation and included in provisional income when withdrawal are made.
#4: Payoff the Mortgage on your Primary Residence
Itemizing deductions will reduce your taxable income, but it will not reduce your provisional income. If you have a home mortgage and an interest bearing savings account in many cases you can improve your after-tax income by using your savings to pay off the home mortgage. Giving up the interest income may be just enough to eliminate the taxation of your social security benefits.
#5: Seek Out Passive Losses
Losses from passive activities, including rental real estate losses, can be used to reduce your MAGI. As long as your AGI is under $100,000 per year, you can use up to $25,000 per year of rental real estate losses to offset your other income. Even when a rental breaks even from a cash flow standpoint it can produce a tax loss because of depreciation deductions. These losses can offset other cash producing investments to improve your after-tax income position.
#6: Force Pass-Through Losses
If you are operating a proprietorship, partnership or S-corporation you can use common tax planning strategies to accelerate deductions and defer revenue. Pass-through losses can offset income from other sources to reduce provisional income.
#7: Harvest Capital Losses
Although only $3,000 of capital losses can be used to offset other income, capital losses should be harvested to offset capital gains. This can prevent spikes in your provisional income that could subject your social security income to taxation.
Benjamin R. Podraza, CPA, MST
February 26, 2013