Retirement Tax Surprise: Understanding Social Security Benefits
As you approach retirement, you may be in for a surprise: your Social Security benefits could be subject to income tax. This may come as a shock, especially if you never saw your parents or grandparents pay taxes on their benefits. However, with rule changes implemented by Presidents Ronald Reagan and Bill Clinton, more and more retirees are likely to pay taxes on their benefits going forward.
The Rising Trend of Taxed Benefits
As of 2022, approximately 48% of Social Security recipients were paying federal income taxes on their benefits. This number is expected to rise to around 56% by 2050, according to the Social Security Administration. It’s essential to understand how your benefits will be taxed to minimize your tax bill.
Calculating Your Taxable Benefits
The formula for calculating taxable benefits is called “combined income” or “provisional income.” To calculate yours, add half of your annual Social Security benefits to your adjusted gross income (AGI), plus any nontaxable interest paid to you. Income brackets then determine how much of your benefits are considered taxable income.
Strategies to Minimize Taxes
A financial advisor can help you develop strategies to minimize taxes on your Social Security benefits. Some strategies include:
- Reducing or delaying retirement withdrawals to lower your provisional income
- Managing your required minimum distributions (RMDs) to minimize taxable income
- Converting tax-deferred accounts to Roth IRAs to reduce taxable income
- Avoiding the “tax torpedo” by considering all retirement income sources
Planning Ahead
It’s crucial to estimate your retirement taxes before collecting pensions, Social Security, and taking withdrawals from retirement accounts. Understanding how RMDs work and their impact on your tax liability is vital. A knowledgeable financial advisor can help you structure and coordinate your income plan to minimize taxes.
Finding the Right Advisor
SmartAsset’s free tool matches you with vetted financial advisors who serve your area. You can have a free introductory call with your advisor matches to decide which one is right for you.
Additional Tips
Remember to keep an emergency fund on hand in case of unexpected expenses. A high-interest savings account can help you earn compound interest while keeping your funds liquid.
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