Taxes on Social Security: From a Financial Advisor
You have worked hard and paid taxes during your career. Now, it’s time to enjoy your Social Security benefits tax-free in retirement, right?
Not exactly. Depending on your household income, up to 85% of your Social Security benefits could be taxable. If you take money from a traditional IRA or 401(k), those withdrawals could be taxable income too.
Understanding how different types of retirement income are taxed may help you manage your finances more effectively.
The Tax Breakdown on Retirement Income
Not all income is taxed the same way in retirement:
● Interest from bank accounts (such as CDs, savings, and checking) is generally taxed as ordinary income.
● Withdrawals from traditional 401(k)s and IRAs are generally taxed based on your current income bracket.
● Investment gains and dividends are generally taxed at 0%, 15%, or 20%, depending on holding periods and total income.
● Roth IRA, Roth 401(k), and HSA withdrawals are typically tax-free and do not impact how Social Security benefits are taxed.
· Social Security taxation depends on your "combined income"—if it exceeds $34,000 for singles or $44,000 for couples, up to 85% of your benefits may be taxable.
So, what can you do to potentially reduce the tax hit? Here are two suggested strategies:
1. Converting to a Roth IRA
One way we suggest managing your tax liability is by converting a portion of your traditional IRA or 401(k) into a Roth IRA. While the conversion itself is taxable, Roth accounts generally offer tax-free withdrawals in retirement, which may help minimize the taxable portion of your Social Security benefits.
A Roth conversion may allow you to:
● Have more control over when and how much you pay in taxes
● Potentially lower your tax burden later in retirement
● Help avoid required minimum distributions (RMDs), which could potentially push you into a higher tax bracket
Since the conversion amount is considered taxable income, it may be beneficial to work with a tax professional to help you determine an amount that’s within your target tax bracket.
2. Delaying Social Security Benefits
Another strategy to consider is postponing your Social Security claim. For every year you delay past your full retirement age (up to age 70), your benefit could increase by approximately 8%.
Let’s look at an example:
Natalie and Juan decide to delay claiming Social Security and instead withdraw more from their taxable IRAs in their late 60s. This helps them manage their tax bracket strategically. By the time they claim Social Security at age 70, their taxable portion of benefits drops from 85% to 46.5%, reducing their overall tax burden by 44%.
Key Takeaways for Retirement Tax Planning
● The more you rely on traditional 401(k) and IRA withdrawals for income, the higher your tax liability may be.
● Social Security benefits are traditionally taxed at a lower rate than many other income sources, which may make them even more valuable in retirement.
● Planning ahead—through Roth conversions and strategic Social Security timing—may help you optimize your retirement income and potentially minimize taxes.
With smart planning, you can potentially maximize your savings, minimize your tax bill, and keep more of what you’ve worked hard to earn.
Sources:
Disclosures:
This information is an overview and should not be considered as specific guidance or recommendations for any individual or business.
This material is provided as a courtesy and for educational purposes only.
These are the views of the author, not the named Representative or Advisory Services Network, LLC, and should not be construed as investment advice. Neither the named Representative nor Advisory Services Network, LLC gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. Please consult your Financial Advisor for further information.
