Avoid the Social Security Tax Trap

Calculating Your Income Level

Filers in either of the first two categories must compute their provisional income—also known as modified adjusted gross income (MAGI)—by adding together tax-exempt interest (such as from municipal bonds), 50% of the year’s Social Security income, as well as any miscellaneous tax-free fringe benefits and exclusions to their adjusted gross income and then subtracting adjustments to income (other than education-related and domestic activities deductions).

Example 1

Jim Lorman is single. He earned $19,500 for the year and received $2,000 of interest income and $1,500 from gambling winnings. He also receives $10,000 in Social Security income. ($19,500 + $2,000 + $1,500 + $5,000 = $28,000)

Jim’s provisional income will come to $28,000. He may thus have to pay taxes on up to 50% of his Social Security benefits.

Example 2

Henry and Sharon Hill have joint earned income of $48,000, plus $4,000 of interest and $3,000 of dividends. Their Social Security benefits come to $20,000:

$48,000 + $4,000 + $3,000 + $10,000 = $65,000

Their MAGI is thus $65,000. They may have to pay tax on up to 85% of their Social Security benefits.

You can use IRS Publication 915 to estimate the amount of taxable Social Security income you will have. Qualified plan participants who also contributed to a deductible IRA must use the worksheets found in IRS Publication 590-A instead. For those who filed as Married Filing Separately and lived at any time with their spouse during the year, IRS Publication 915 states that up to 85% of your Social Security may be taxable regardless of the sum.

How to Lower Your Social Security Taxes

There are several remedies available for those who are taxed on their Social Security benefits. Perhaps the most obvious solution is to reduce or eliminate the interest and dividends that are used in the provisional income formula. In both of the examples shown above, the taxpayers would have reduced their Social Security tax if they hadn’t had declarable investment revenues on top of their other income.

The solution could thus be to convert the reportable investment income into tax-deferred income, such as from an annuity, which will not show up on a Form 1040 until it is withdrawn. If you have $200,000 in certificates of deposit (CDs) earning 3%, which translates into $6,000 a year, that will be counted as provisional income. But the same $200,000 growing inside an annuity, with the interest reinvested back into the annuity, will effectively yield a reportable interest of $0 when computing provisional income.

Generally, annuities become taxable income when they are taken as distributions depending on the account type. Virtually any investor who is not spending all of the interest paid from a CD or other taxable instrument can thus benefit from moving at least a portion of his or her assets into a tax-deferred investment or account.

Earmarking Retirement Accounts

Another possible remedy could be to work a little less, especially if you are at or near the threshold of having your benefits taxed. In the first example listed above, if Jim were to move his taxable investments into an annuity and earn $1,000 less, he would have virtually no taxable benefits. Shifting investments from taxable accounts into a traditional or Roth IRA will also accomplish the same objective, provided funding limits have not been surpassed. 

IRA Contribution Limits

The IRS has established contribution limits for contributing new money into an IRA. The annual contribution limit to both a traditional IRA and a Roth IRA is $6,000 per year for 2021 and 2022. Individuals aged 50 and over can deposit a catch-up contribution of $1,000 per year. The contribution limit for a 401(k) is $19,500 per year for 2021 and $20,500 for 2022. If you are 50 or older, you can contribute an additional $6,500 as a catch-up contribution each year. 

IRA Distributions

A leading way is to withdraw funds early—or “make distributions,” in the retirement parlance—from your tax-sheltered retirement accounts, such as IRAs and 401(k)s. Keep in mind that you can make distributions penalty-free after age 59½. That means you avoid paying the penalty for making these withdrawals too early. If you withdraw your IRA funds before the age of 59½, in most situations, you’ll pay a 10% penalty on top of having to pay income taxes on the distribution.

Since any withdrawals are taxable, they must, of course, be planned carefully with the other taxes you will have to pay on income for the year. The goal is to pay less in tax by making more withdrawals during this pre-Social Security period than you would after you begin to draw benefits. That requires considering the total tax bite from withdrawals, Social Security benefits, and any other sources.

Be mindful, too, that at age 72, you need to take required minimum distributions (RMDs) from these accounts, so you need to plan the funds for those mandatory withdrawals.

The Bottom Line

There are many rules concerning the taxability of Social Security benefits, and this article attempts to cover only the major rules and issues related to this topic. For more information on this topic, visit the IRS website and download IRS Publication 915 or consult your tax advisor.