Reducing the Taxes You Pay
on Your Social Security Benefits

In my last Retirement Coach Strategy of the Week, we talked about the surprise that awaited thousands of Americans this year when they went to file their income tax return.

And, that surprise was that they had to pay income taxes on their social security benefits that they started collecting in 2011!

Yes, it’s still hard to believe for some. You work and pay taxes your entire life. And, now when you turn around and begin collecting the benefits from the system you’ve paid payroll taxes to participate in over the course of your life, you have the distinct honor of paying more income taxes.

Well, this week, we’re going to talk about how you can potentially reduce or eliminate income taxes on your social security benefits so you can keep more of the money you’ve worked your entire life to save instead of having it end up in the pockets of the federal government.

Refresher Course

Just as a quick refresher, the taxes you owe on your social security benefits depend on the amount of “other” income you have (known as “provisional” income).

Key Point: If social security represents the only income you have, there are no taxes due.

However, if you are married and your “provisional” income is between $32,000 and $44,000, up to 50% of your social security benefits are subject to income taxes.

Once you hit $44,000 of provisional income, up to 85% of your benefits are taxable.

So, the key strategy is to somehow limit the amount of your ‘other’ taxable income reported on your tax return.

As we discussed last week, in addition to your social security income, if you have a fixed monthly pension of $44,000 or more, there is not much you can do. Unfortunately, 85% of your social security income will be taxed.

However, if you don’t have a fixed monthly pension, you have some tax planning strategies that you’ll want to consider.

Think about this for a minute. Once your income (outside of social security) reaches $32,000, any additional income you might have will create sort of a “double tax” because the additional income makes more of your social security income become “taxable”.

In other words, you’ll owe income tax on the additional income itself and more tax on your social security benefits. So, any steps you can take to bring down your provisional income will have a “double” tax reduction effect.

As an example, let’s assume that you’re receiving $30,000 of social security benefits, and your other provisional “taxable” income is $32,000.

If you can reduce your ‘provisional’ income by $4,000 (to $28,000) by shifting some of the sources of their taxable income to non-taxable, not only will you reduce your taxable income by $4,000, but you also shield another $2,000 worth of social security benefits (50% of $4,000) from taxes!

In other words, trimming your ‘provisional’ income by $4,000 reduces your total taxable income by $6,000!

Even at the 15% federal tax bracket (and 5.25% for MA residents), that’s a savings of over $1,200.

While that’s not all the money in the world, that’s an extra $100 per month you just freed up to go out to dinner each month that would have gone to taxes.

Reducing Your Taxable Income

Now that we know all of this, let’s talk about some strategies to reduce your other ‘provisional’ income:

Taxable Interest and Dividends: The first place to look is your taxable interest and dividends you receive from bank accounts, CDs, and bonds. If you’re not spending this interest and dividends, why pay taxes on them if you don’t have to. There are two strategies to consider:

  • First, if you need to own stocks (or stock mutual funds) in your overall investment portfolio to keep pace with inflation (which you should), you’re better off holding them outside of your IRA rather than inside your IRA, especially low dividend paying stocks.
  • Left alone, they will generate little or no current taxable income, thus reducing your “other” income for the purpose of calculating the income taxes you owe on your social security income.

    Given the choice, hold your bonds and money market funds inside of your IRA so the interest accumulates tax deferred until you tap your IRA.

  • Second, as you’ve heard me mention before, I’m not a huge fan of annuities. However, one of the real benefits you can take advantage of in your social security tax planning is deferring your taxable income using tax deferred annuities. Earnings in tax deferred annuities accumulate tax free until you withdraw them, so they remove taxable interest from your adjusted gross income today.

Now, before you jump right into them, please understand that fees on annuities can potentially be substantial, so check very carefully. However, there are a few that can still be very effective in reducing your taxes and piling up your savings. The good news is that there are a handful of companies out there who offer extremely low-cost tax deferred annuities which are far more attractive in helping you defer taxes at very little cost.

Where You Draw Income: If you’re drawing income from your IRAs, all of that is taxable, and it drives up your provisional income for social security tax purposes. If you’re under the age of 70 ½, take a look and see if you can draw that income from your “non-IRA” investments instead.

Capital Losses: Pay close attention to your gains and losses in your investments held outside of your IRA. Look for places to lock in $3,000 worth of capital losses each year. This is the most you can deduct each year against your other/provisional income.

Tax Credits: Tax credits don’t reduce your provisional income. Tax credits offset your actual taxes due dollar for dollar on all income, so they are tremendously powerful. There are many ways to get tax credits such as having more children or adopting children. However, it’s not likely that you’ll be having more children at this stage in your life, even if it means paying less taxes!

Take a look at affordable housing tax credit funds. For a rather small investment, you can receive a stream of tax credits for 10 years and reduce the income tax you pay, not only on your social security income, but on all of your other taxable income. Because of AMT, offerings of these are limited. However, they are available on the secondary market.

In the big picture, what all of this tells us is that you really need a complete “Retirement Income Withdrawal Strategy” for each year of your retirement, where you’ve strategically outlined not only how much you need to withdraw each year, but where the best place is to draw your income from.

You can no longer make your investment planning decisions and your tax planning decisions in a vacuum.

They have to be made simultaneously taking all factors into consideration at once.

Not having a “Retirement Income Withdrawal Strategy” most likely leads to you paying far more taxes than you have to. And, why would you choose to do that?

Committed To Your Relaxing Retirement,

Jack Phelps
The Retirement Coach

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