5 Ways to Lower Your Social Security Tax Bill

Social Security retirees are staring down the barrel of one of the largest increases to benefits in decades in 2023. That’s because high inflation should translate into a high cost of living adjustment (COLA) to benefits in order to help retirees keep up with higher prices. That COLA increase, however, could also result in retirees paying more taxes on their Social Security benefits if the increase pushes more of their combined income over certain thresholds.

Individuals with a combined income of more than $25,000 will have to pay taxes on as much as half of their Social Security benefits that exceed that threshold. Individuals with a combined income of more than $34,000 will have to pay taxes on as much as 85% of their benefits. For married couples, those numbers are $32,000 and $44,000, respectively.

With this in mind, retirees may want to consider ways they can lower their Social Security tax bills. Luckily, there are several ways to effectively do this. Here are five.

1. Contribute to an IRA

As you get older and start to approach the age at which you can qualify for Social Security, it may be wise to have multiple retirement accounts such as an individual retirement account (IRA) and a Roth IRA. You likely will have at least one as you get older.

The two accounts have different purposes, but a traditional IRA can be useful because contributions throughout the year are tax-deductible, and you can contribute as much as $6,000 or $7,000 depending on your age. However, you must have earned income to make IRA contributions, so those who aren’t working wouldn’t be able to do this. If you’re not enrolled in a workplace retirement plan, your contributions are 100% tax deductible. If you are covered, you can still contribute to an IRA and receive some level of deduction.

This deduction could give you some flexibility if your combined income is approaching a tax threshold. Think about if you have $27,000 in combined income and then are able to contribute $2,500 to an IRA. That will bring your combined income under $25,000 and exclude your Social Security benefits from counting as taxable income.

2. Utilizing a Roth IRA

Roth IRAs are different from traditional IRAs because you contribute to them with after-tax dollars and you don’t pay taxes on your earnings in the account. Furthermore, you can withdraw money from an IRA tax-free after the age of 59 1/2.

These withdrawals also will not count toward your combined income, which could be tremendously beneficial if you are nearing a threshold. So if you can replace other sources of income in any given year with Roth IRA withdrawals, that is one way to keep your taxable income lower.

Even better, it’s possible to convert funds from a traditional IRA to a Roth IRA to take advantage of the tax benefits of a Roth IRA later down the line. The amount you convert does typically count as taxable income, so be aware of how that impacts your current year’s income. It may also be advantageous to think about doing this before you start receiving Social Security benefits.

3. Donate IRA distributions

Although IRA contributions can be helpful, there are also some drawbacks. If you are enrolled in a workplace IRA plan there will likely be required minimum distributions (RMD), which mandate the retiree to withdraw a certain amount from the account by the time they reach the age of 72. These do usually count toward your taxable income.

If an RMD is going to push you over a certain threshold, then it might be smart to donate this amount to charity, which could then shrink your combined income. This strategy, however, is only an option for people who are 70 1/2 or older. If you do qualify you can contribute as much as $100,000 from your IRA, which will keep this income from being taxed.

4. Buy a QLAC

Another way to reduce your RMDs is to purchase a qualified longevity annuity contract (QLAC). In an annuity, a retiree makes a lump-sum payment up front, which will come back to them later through monthly distribution payments down the line. It’s another way for retirees to prepare for the future as they get older and make sure they have enough income to support them.

QLACs must be a deferred income annuity meaning that payments, which are made from a person’s pre-tax IRA, can’t begin for at least a year until after the contract is purchased, although they can be deferred much further off in the future up until the age of 85

In a QLAC, retirees can take $145,000 or 25% of their IRA balance from what it was at the end of the prior year, whichever of the amounts is smaller. That means that you can take $145,000 if your IRA balance is $580,000 or more or 25% of your IRA if the balance is below $580,000.

This effectively reduces the amount of money in your IRA, which is how the RMDs are calculated. So the fewer assets in your IRA, the smaller your RMDs will be, which results in less combined income during the deferral period.

5. Tax-loss harvesting

Tax-loss harvesting can be used in any tax strategy but should not be overlooked for reducing the amount of your Social Security benefits that get taxed as well. If you invest in stocks or bonds and have some losses on your books, you can sell those positions for a loss, which then turns into a tax deduction.

The deduction is weighed against your other capital gains, which count toward your combined income. So if you have $4,000 in capital gains in a given year and then sell some assets for a $2,000 loss, that loss will be deducted from the $4,000, resulting in only $2,000 in capital gains. You never know, it could be the difference in keeping you under a tax threshold.

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