Social Security benefits can make up a significant source of income for many retirees, so it’s wise to ensure you’re making the most of them.
The average benefit amount is around $1,657 per month, according to the Social Security Administration. You may not receive as much as you’re anticipating, however, because there’s one expense that could take a bite out of your payments: taxes.
You could be subject to both state and federal income taxes on your benefits in retirement. But by contributing to a Roth IRA, you could potentially reduce those taxes and keep more of your Social Security. Here’s how.
How taxes can affect your benefits
Your state taxes will be determined by where you live. Each state has different regulations regarding Social Security, but the good news is that 38 states don’t tax benefits.
The 12 states that do tax Social Security include Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, Rhode Island, Utah, Vermont, and West Virginia. (North Dakota previously taxed benefits as well, but as of 2021, Social Security is exempt from income taxes in the state.)
Even if you already live in a tax-friendly state, though, you could still be subject to federal taxes. Your federal taxes are based on a figure called your “combined income.” This is half of your annual Social Security benefit amount, plus the rest of your adjusted gross income.
Percentage of Your Benefits Subject to Federal 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 regardless of your income, you won’t pay federal taxes on more than 85% of your benefits. The bad news, though, is that to get out of paying federal taxes altogether, your combined income has to be under $25,000 per year (or $32,000 per year for married couples).
How a Roth IRA can reduce your tax bill
If you’re contributing to a Roth IRA, you may be able to lower your federal taxes. Roth IRA contributions don’t count toward your combined income, which can potentially reduce or even eliminate federal taxes on Social Security.
For example, say you’re receiving $20,000 per year from Social Security and are withdrawing $40,000 per year from a 401(k). In this scenario, your combined income would be $10,000 plus $40,000, or $50,000 per year. This would put you in the highest tax range.
On the other hand, say you’re still collecting $20,000 per year in benefits, but instead of withdrawing $40,000 per year from a 401(k), you’re pulling it from a Roth IRA. In that case, your combined income would be only $10,000 because the $40,000 in Roth IRA withdrawals won’t count toward your combined income. That would result in paying zero federal taxes on your benefits.
Should you invest in a Roth IRA?
There are plenty of advantages of contributing to a Roth IRA for retirement, but if you’re considering moving from a 401(k) or a traditional IRA to a Roth, be sure to think about the pros and cons before you make the switch.
If you’re earning employer-matching contributions through your 401(k), it’s wise to continue investing at least enough to earn the full match. And if you’re thinking about moving your traditional IRA savings to a Roth IRA, keep in mind that you’ll need to pay taxes on the amount you roll over.
Investing in a Roth IRA can be a fantastic way to prepare for retirement. With the right strategy, you can potentially lower your taxes and, in turn, collect larger Social Security payments each month.
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