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Taxes are an inevitable aspect of life, and by the time retirement arrives, many individuals find themselves well-acquainted with them. However, the experience of paying taxes on various income sources can often differ, particularly when it comes to Social Security benefits.
One primary reason retirees may harbor resentment toward taxes on their Social Security is the perception of double taxation. You earn these benefits by contributing taxes throughout your working life, and the amount you receive monthly corresponds to your lifetime tax contributions. Thus, having to pay taxes on the benefits themselves can feel unjust.
Furthermore, the income thresholds at which Social Security benefits become taxable are relatively low, disheartening many retirees who might not have expected to owe taxes in this area. Nevertheless, a strategic financial move could help you minimize or avoid these taxes altogether.
Understanding the Taxation of Social Security Benefits
Whether you need to pay taxes on your Social Security benefits isn’t predetermined; it hinges on a figure known as “combined income.”
Your combined income is determined by summing your adjusted gross income, one-half of your annual Social Security benefits, and any non-taxable income, such as interest from municipal bonds.
If you file taxes as a single individual and your combined income exceeds $25,000, you might end up owing taxes on your benefits. For couples filing jointly, this threshold rises to $32,000.
Strategies to Reduce Taxes on Social Security Income
If retirement is still on the horizon, consider a financial strategy that could help keep your combined income below the taxable threshold. One effective approach is to invest in a Roth IRA or consider converting funds to a Roth account before you retire.
The allure of a Roth IRA lies in its tax-free withdrawals, which do not count as taxable income; consequently, they don’t factor into your total combined income. This means that if you have minimal tax-exempt interest or additional non-taxable income, you could potentially remain under the combined income limit, particularly if the main contributor to that figure is half of your Social Security benefits.
However, achieving sufficient retirement funding in a Roth IRA presents its challenges. Contribution limits are relatively modest, and higher-income individuals may face restrictions that prevent direct contributions. Likewise, timing Roth conversions requires careful planning to avoid a hefty tax burden during the conversion year.
Still, focusing on Roth IRA investments during your working years is a viable strategy for bypassing taxes on Social Security benefits upon retirement. Additionally, you would benefit from tax-free withdrawals without the concern of required minimum distributions (RMDs).
When utilizing traditional accounts like a 401(k) or traditional IRA, taxes on contributions are deferred until withdrawal. However, RMDs necessitate annual withdrawals from these accounts—thus, incurring taxes and potentially limiting your control over your retirement assets. In contrast, a Roth IRA allows for greater flexibility and potential tax savings, making it an attractive option for those aiming to protect their Social Security income from taxation.
Source
www.fool.com