Income taxes are often high enough during your working years, but some people will have to pay taxes during their retirement—on their Social Security income. Even though they paid into the system for years, the Internal Revenue Service (IRS) still wants a portion when they start receiving their benefits. As many as 56 percent of people on Social Security pay taxes on their benefits.
Like all other federal taxes, these taxes are based on your income. When you retire, you may have multiple sources of income that include pensions, retirement accounts such as IRAs or 401(k)s, and more. When added together, your income could easily surpass the income levels permitted.
The Income Limits DefinedWhen the IRS looks for taxable money, it counts all your income. The IRS says supplemental security income (SSI) payments are an exception. These payments are not taxable and are not considered part of your income.
When calculating your income, you only count half of your Social Security benefits and all other income (you must include tax-exempt interest). Individuals (including heads of household and a qualifying surviving spouse) earning $25,000–34,000 will have to pay tax on half their benefits. This ceiling level also applies to married people who file separately but have lived apart for the entire year. When singles earn more than $34,000, as much as 85 percent of their Social Security benefits are taxable. The remaining 15 percent will never be taxed.
Married couples that file jointly earning $32,000–44,000 will have to pay taxes on half of their Social Security benefits. If they are still married but lived with their spouse for any time during the year, all income is taxable. When married couples filing jointly earn more than $44,000 combined, they will pay taxes on up to 85 percent of their benefits.
Some States Also Tax Retirement BenefitsBesides paying tax on your Social Security benefits to the IRS, you may live in a state where it also collects taxes on retirement benefits. Investor.Vanguard says that 13 states currently tax Social Security income. They include Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont, and West Virginia. Some of these states may be changing who they tax in the next few years.
How to Reduce or Eliminate Social Security TaxesHaving more income that puts you above the tax-free limits means you need to reduce it to fit within those tiers. If you are not yet receiving money from an IRA or 401(k), you can convert it to a Roth 401(k) or a Roth IRA. These retirement accounts do not have any required minimum distributions, enabling you to keep it in the account as long as you want—and it keeps growing.
When you make the conversion, you must pay taxes on the conversion amount. Taxes are due because money put into a traditional IRA or 401(k) is contributed tax-free, enabling you to get a tax deduction. The one catch on conversion is that the money must be in the account for five years before getting any tax-free withdrawals.
Taxes Can Be Withheld From Your Social Security BenefitsNear the start of each year, you will receive a statement from the Social Security Administration (SSA) informing you how much is owed in Social Security taxes from the previous year. Once you know that amount, the SSA says you can make estimated tax payments quarterly, or you can have the government withhold the taxes for you by going to SSA.
If you are not yet receiving Social Security retirement benefits, you can develop a strategy with a financial advisor as to the best way to reduce your taxes. People already getting Social Security benefits should talk to a financial expert to learn their best tactics for tax reduction tips.