When you claim Social Security, up to 50% to 85% of your benefit is taxable, depending on your overall income level. You may find that the combination of Social Security benefits, withdrawals from tax-deferred IRAs and other sources of income results in a tax bill higher than you anticipated.
The years leading up to retirement are some of the best times to get a handle on what your post-retirement tax picture will look like. After all, it isn’t how much income you’re getting in retirement that’s important — what’s important is how much of that income you keep to fund your lifestyle and other retirement goals.
Once you understand how various retirement accounts are taxed and how those taxes will affect other retirement benefits, like Social Security, you can make informed decisions about how to position your finances in retirement to help mitigate taxes.
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In this article, I’ll explain which of your retirement income streams are likely to be taxed, and the steps that you can take to potentially minimize those taxes.
Taxes in retirement
Here’s a brief summary of how different types of retirement accounts and income are taxed in retirement:
- Social Security: Up to 50% to 85% taxable
- Traditional IRA accounts: Taxable at individual income tax level when withdrawn in retirement
- Roth IRA accounts: Tax-free when withdrawn after a five-year holding period
The degree to which Social Security is taxed depends on your individual income and filing status. If you align your income appropriately, you can potentially pay no taxes on your Social Security benefits and reduce your tax bill significantly.
The case studies below show you an example of how this can work.
Case study facts
Meet Rick and Amanda, a retired couple in their early 70s. They file their taxes as married filing jointly and need $120,000 a year to fund their lifestyle. They receive $60,000 a year in Social Security benefits and source the rest of their income from their investment accounts.
Here’s how different withdrawal strategies affect their taxes:
Scenario No. 1: Pulling from IRA triggers big tax bill
Rick and Amanda receive their $60,000 a year in Social Security benefits. To get the remaining $60,000 to meet their income needs (net of federal taxes), they withdraw $72,000 from their traditional IRA.
Because traditional IRA withdrawals count as fully taxable income, their Social Security benefits are subject to taxation.
Based on the IRS formula for Social Security taxation, 85% of their Social Security — $51,000 — becomes taxable income. This means their total income for tax purposes is $123,000 ($72,000 IRA distribution plus $51,000 in taxable Social Security benefits).
After applying the $33,200 standard deduction, their final taxable income is $89,800, which results in a total federal tax bill of $10,299.
So, they needed a total income of $132,000 to pay the federal tax bill and have enough left to fund their living expenses.
Scenario No. 2: Pulling from Roth delivers big savings
Rick and Amanda receive the same amount of Social Security, which is $60,000. To meet their income needs, they take a $60,000 distribution from their Roth IRA, which is tax-free.
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Because they are not tapping a taxable traditional IRA, it reduces the tax on their Social Security to zero and their overall tax liability to zero.
While this approach reduces their tax bill to zero, it isn’t sustainable unless they have a large balance in their Roth.
Scenario No. 3: Pulling from both offers sustainable savings
Rick and Amanda receive the same $60,000 in Social Security benefits. To fund their income needs, they take a distribution from their traditional IRA of $24,000. To meet the rest of their income needs, they take a $36,000 tax-free distribution from their Roth IRA. This combination results in a tax bill of $530.
This approach maximizes their situation by reducing their withdrawal from their Roth while reducing their tax bill to close to zero.
Takeaways
Based on these scenarios, you can see that Social Security tax rates aren’t a prescription that applies to everyone on a uniform basis. Instead, like everything else, Social Security tax is dependent upon your total income picture.
When you plan ahead and have other sources of income, like Roth IRA distributions and cash in taxable investment accounts or bank accounts, you can take steps to potentially reduce taxes on your Social Security benefits and your overall retirement income.
Amy Buttell contributed to this article.
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This information does not necessarily represent the views of the presenting adviser. The statements and opinions expressed are those of the author and are subject to change at any time. Provided content is for overview and informational purposes only and is not intended and should not be relied upon as individualized tax, legal, fiduciary, or investment advice. All information is believed to be from reliable sources; however, presenting insurance professional makes no representation as to its completeness or accuracy.
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