Social Security is a critical income source for millions of seniors, and while you'll often hear that it's not advisable to live on those benefits alone, the reality is that many seniors do. But some people do a good job of saving for retirement and securing other income streams. As such, their benefits represent just a portion of their total senior income.
That's really a more ideal situation. But seniors with outside income take one big risk — getting taxed on their Social Security benefits. And worse yet, the rules regarding those taxes haven't changed in years, and seniors often feel the pain because of that.
An outdated set of guidelines
Seniors who don't have income outside of Social Security can generally avoid taxes on their benefits. But those with additional income often get penalized in the form of taxes.
The taxation of benefits hinges on a calculation known as provisional income, which is a senior's non-Social Security income plus half of his or her annual benefit.
Seniors face taxes on up to 50% of their benefits once their provisional income exceeds $25,000 for singles and $32,000 for married couples. They then face taxes on up to 85% of their benefits once their provisional income exceeds $34,000 and $44,000, respectively.
The problem, though, is that these thresholds have been in place for decades. In 1983, the decision was made to tax up to 50% of benefits at the aforementioned levels. In 1993, that rule was amended to tax up to 85% of benefits, also at those same levels.
Meanwhile, the cost of living has risen substantially since then — yet the income thresholds for Social Security taxes haven't. And that leaves seniors in a pretty bad spot.
Avoiding taxes on benefits
Seniors who save for retirement strategically may be able to avoid getting slammed with taxes on their Social Security benefits. And one of the easiest ways to make that happen is to save in a Roth IRA.
Roth IRA withdrawals are not taxable income and also don't count toward provisional income. As such, a single tax filer who collects $18,000 a year in Social Security and also takes $24,000 a year in Roth IRA withdrawals would not have to pay taxes on benefits, despite having a total income of $42,000 and a provisional income of $33,000.
While higher earners aren't allowed to contribute to a Roth IRA directly, there's always the option to fund a traditional IRA and then convert it to a Roth account afterward. It's a move worth making, considering that Roth IRAs offer other benefits in retirement outside of helping seniors avoid taxes on Social Security. For example, Roth IRAs are the only tax-advantaged retirement plan to not impose required minimum distributions.
It's bad enough that seniors face taxes on their Social Security income. But what makes the problem worse is the fact that the income thresholds that determine that haven't changed in multiple decades.
There's already pressure on lawmakers to change the way Social Security raises are calculated. Senior advocates should consider encouraging lawmakers to revisit these tax rules, as well.
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