Social Security benefits are of course taxable, but there are limits. Generally, if Social Security is your only income during retirement, you won’t have to pay any taxes. But if you have additional income such as withdrawals from an IRA, your benefit will likely be taxed.
If you’re able to go without the extra income, these eight tips can help keep your income below the threshold, or at least minimize what you pay.
Step 1: Roth IRA
Take as much income as possible from a Roth IRA rather than a traditional IRA. Why? First, Roth IRA withdrawals are tax free. That’s because you pay income tax on money before putting it into a Roth IRA. Second, Roth IRA withdrawals do not count as part of your income for purposes of determining your Social Security benefits’ tax vulnerability. Third, Roth IRAs are exempt from mandatory annual withdrawals after you reach age 70-1/2. (Those withdrawals are known as required minimum distributions, or RMDs.)
The best scenario is if you’ve been saving in a Roth IRA for years. If you have not, you’ve got to decide whether to convert savings in a traditional IRA to a Roth IRA. If you do such a conversion, the amount you transfer is subject to income tax.
Step 2: Live In A Tax-Friendly State
If you can — perhaps as part of your retirement preparations — relocate to one of the 37 states that do not tax Social Security income.
Some states that do tax Social Security income offer deductions or exemptions based on your age or income.
Step 3: IRA Charity
If you are age 70-1/2 or older, you are allowed to give up to $100,000 annually tax-free to charity from a traditional IRA (as well as from rollover, inherited, SEP or Simple IRAs).
That helps your tax vulnerability two ways. First, the donation counts toward fulfilling any requirement you face for taking RMDs from a traditional or other IRA, once you pass age 70-1/2. But the withdrawal does not get included in calculating whether your income and benefits are subject to tax and by how much.
This maneuver is only allowed if it’s done as a direct transfer from your IRA to the charity.
Step 4: Donate Appreciated Securities
Securities that have risen in value should be donated rather than cashed out and then donated. If the security is in a taxable account, it gets rid of an asset that could become a capital gain that inflates your income.
But if you sell the security to raise cash for a charitable donation, you create a taxable capital gain and you create income, which can increase the odds that your Social Security benefits get taxed and by how much.
Step 5: Buy A ‘QLAC’
You can shift some IRA money into a type of deferred-income annuity known as a qualified longevity annuity contract (QLAC), which is another way to reduce the size of your traditional IRA and can cut your annual income by slenderizing the size of your RMDs.
You’re allowed to invest as much as $130,000 or 25% of your IRA balance — whichever is the smaller amount.
A QLAC starts to pay you a guaranteed annual income later in life. You begin at any age between 70-1/2 and 85.
The guaranteed aspect of QLAC income is a key selling point. Still, in exchange for that certainty, make sure you are not giving up too much in yield. How does the yield on a QLAC you’re considering compare to the yield on, say, an intermediate-term bond mutual fund? And how many years will it be before your QLAC starts to pay income? Is that lost opportunity cost-effective?
And, remember, once QLAC payouts begin, they are included in your taxable income, making it harder in the future to avoid or cut taxes on your Social Security benefits.
Step 6: Stick With Growth Investments
Favor growth-oriented investments by removing money from income-oriented assets such as dividend-paying stocks, stock funds, bonds and bond funds with above-average yields.
Growth stocks and funds reinvest profits into activities intended to help them grow, rather than pay out lots of their profits in the form of dividends or share buybacks.
Step 7: Avoid Capital Gains
Remember, your mutual funds can generate capital gains even when the fund shares lose value. Checking a fund’s distributions history can give a rough idea of a fund’s cap gains tendency. Same for checking its turnover rate.
You can always sell your shares before distributions are made. Check a fund’s webpage to see when it tends to make distributions.
Step 8: Harvest Tax Losses
If you do have capital gains, offset them by realizing any capital losses you may have.
“If an investment has gone down, sell it to lock in the loss, which can offset some gains and reduce your income for purposes of determining whether your Social Security benefits are taxable and, if so, by how much,” Carcone said.
Keep scrolling down to read “Five Ways to Maximize Social Security Benefits” on Money & Markets.