It can be tough to make ends meet in retirement, especially if you don’t have a significant amount in savings. Fortunately, Social Security benefits can help bridge the gap between what you have saved and what you need to pay the bills.
The bad news, though, is that taxes can take a chunk out of your benefits in retirement. Although you’ve been paying Social Security taxes throughout your career, your monthly checks may still be subject to both state and federal income taxes.
State taxes will depend on where you live, and there’s a good chance you may already be off the hook for them. And there’s one simple way to avoid paying federal taxes on your benefits, too.
How taxes will affect your benefits
Whether you’ll owe state income taxes on your benefits depends on where you live. Currently, only 13 states tax benefits — including Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont, and West Virginia. If you don’t live in one of these states, you’re off the hook for state taxes on Social Security.
When it comes to federal taxes, however, your “combined income” in retirement will determine how much you owe.
Your combined income is half of your annual benefit amount plus your adjusted gross income. So, for example, if you’re receiving $20,000 per year in benefits and are withdrawing $30,000 per year from your 401(k), your combined income would be $10,000 + $30,000, or $40,000 per year.
How much of your benefit amount that is subject to taxes will depend on your marital status and your combined income.
Benefit Amount Subject to Taxes
Combined Income for Individuals
Combined Income for Married Couples Filing Jointly
Less than $25,000 per year
Less than $32,000 per year
Up to 50%
$25,000 to $34,000 per year
$32,000 to $44,000 per year
Up to 85%
More than $34,000 per year
More than $44,000 per year
The good news is that you’ll never pay taxes on more than 85% of your benefit amount. But if your combined income is higher than $25,000 per year (or $32,000 per year for married couples), you’ll owe federal income taxes on at least a portion of your monthly payments.
How to get out of paying federal taxes
While you may not be able to reduce your income enough to avoid taxes, there is a caveat: Roth IRA withdrawals don’t count toward your combined income.
Take the example above, for instance. Say you’re still earning $20,000 per year in benefits, but instead of withdrawing $30,000 per year from a 401(k), you’re taking it from a Roth IRA.
In this case, your combined income would only be half your annual benefit amount, or $10,000 (assuming you don’t have any other sources of income). That would put you under the income limit, so you would not owe federal taxes on your benefits at all.
Of course, if you’ve already invested a substantial amount of money in a 401(k) or traditional IRA, it may not be realistic to convert those savings into a Roth IRA (since you’ll need to pay income taxes on the amount you roll over).
However, if you still have time to save for retirement, it may be worthwhile to consider contributing to this type of account. The more you’re able to save in a Roth IRA, the more you’ll be able to reduce your Social Security taxes in retirement.
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