How to Avoid the Social Security Tax Torpedo (2024)

While retirees may be chagrined to discover that taxes don’t end when they leave the workforce, an unseen threat looms behind the U.S. tax code. The Social Security tax torpedo is as destructive as it sounds, blowing up the budgets of unsuspecting retired folks eagerly awaiting their first Social Security check. Having a clear understanding of your Social Security taxes could help you dodge this torpedo in retirement. Here’s what you need to know.

A financial advisor can help you create a financial plan to minimize your taxes in your golden years.

What Is Social Security Tax Torpedo?

The Social Security tax torpedo is a spike in taxes retirees can experience after receiving Social Security income. Specifically, 50% to 85% of your Social Security check may be taxable, depending on your income level and life circ*mstances. In addition, your Social Security income can increase your marginal tax rate, meaning the top portion of your income enters the next tax bracket. As a result, unsuspecting retirees can pay heavier taxes than anticipated, and their Social Security benefits provide less of a financial boost than expected.

Tax Torpedo Implications

The government bases your taxes in retirement on your modified adjusted gross income plus any nontaxable interest (usually from municipal bonds) and half of your Social Security benefits. The resulting sum is called your ‘combined income,’ which incurs different taxes depending on the amount and the filer’s status.

For instance, single filers with a combined income of $25,000 to $34,000 pay taxes on 50% of their benefits. An income above this amount results in taxes on 85% of the benefits. Likewise, those married filing jointly with combined incomes between $32,000 and $44,000 will pay taxes on 50% of their benefits. Any amount above this incurs taxes on 85% of the benefits.

Remember, the tax torpedo doesn’t mean you will lose 85% of your Social Security income taxes. Instead, you’ll owe your regular income tax rate on 85 cents of every dollar you receive from Social Security. In addition, your income tax rate isn’t the same across all your income because of how tax brackets work. The US tax code incurs progressive taxes on your income the higher it is.

For example, say you’re a single filer in 2023 with a total taxable income of $50,000 (putting you in the 22% tax rate for the income above $44,725). Your combined income is $35,000, and you receive $15,000 in Social Security benefits. You’re over the $34,000 combined income limit, meaning you’ll pay taxes on 85% of your Social Security benefits.

This situation means applying your top marginal tax rate (22%) to 85% of your Social Security benefit ($12,750). So, your tax burden from Social Security is a $2,805 expense. If your combined income was $34,000 or less, only half your Social Security would be taxed, a $1,650 expense.

How to Avoid the Social Security Tax Torpedo

Losing your hard-earned Social Security benefits to Uncle Sam isn’t a foregone conclusion. Here’s how to sidestep the Social Security tax torpedo while maximizing your financial wellness and quality of life:

Use a Roth IRA

Roth IRAs are retirement accounts where contributions are made with after-tax dollars, meaning you don’t get a tax deduction when you contribute. However, the distributions during retirement are tax-free. As a result, your Roth IRA income doesn’t count towards your taxable income, reducing the likelihood that you’ll pass the threshold that determines whether 50% or 85% of your Social Security benefit is taxed.

Live in a Tax-Friendly State

Thirteen states tax your Social Security check, adding to the federal tax burden. As a result, you can save on taxes by avoiding residency in the following states:

Give Your IRA Income to Charity

Qualified charitable distributions (QCDs) allow you to donate money directly from your traditional IRA to charity. The government doesn’t count the first $100,000 of donations as taxable income. While doing so won’t directly affect your Social Security tax, it will lower your overall taxable income, potentially reducing the portion of your Social Security benefits subject to taxation. Remember, this advantage is solely for traditional IRAs.

Buy a Qualified Longevity Annuity Contract (QLAC)

A QLAC is a specialized annuity that provides a guaranteed income stream later in life. You can transfer $130,000 from a traditional IRA or 401(k) to a newly opened QLAC, reducing the required minimum distributions (RMDs) you’ll take from your retirement account. This way, the distributions from your 401(k) or IRA won’t increase your annual income as much, mitigating Social Security taxes.

Your QLAC has a delayed RMD age compared to traditional retirement accounts. While the government requires RMDs from a 401(k) or IRA at age 73, you can delay distributions from your QLAC until you’re 85. Remember, you will owe taxes from QLAC distributions the year you receive them.

Compare Your Income Level to Tax Brackets

Understanding the income thresholds for different tax brackets can help you plan withdrawals from retirement accounts. By staying within lower tax brackets, you may reduce the portion of your Social Security benefits subject to taxation.

Delay Social Security

Taxes on Social Security income can’t apply until you receive your benefits. Therefore, delaying Social Security can help you avoid additional taxation through your 60s. If you can work or survive on other income until age 70, you’ll reap two benefits: first, you’ll maximize your Social Security payment amount. Second, you’ll avoid paying taxes on Social Security. Plus, if you live on a traditional IRA or 401(k) during that time, you’ll reduce your RMDs, giving you more control over your income level in your 70s.

Bottom Line

Understanding and proactively addressing the possibility of a Social Security tax torpedo can increase your net income during retirement. By utilizing tools like Roth IRAs, charitable donations, and QLACs, you can create a more tax-efficient retirement.

Additionally, being mindful of how your income level relates to tax brackets and considering delaying Social Security can provide further avenues to optimize your financial well-being and quality of life in retirement. Consulting a financial advisor can be instrumental in tailoring these strategies to your specific circ*mstances, helping you maximize your hard-earned retirement benefits.

Tips for Avoiding the Social Security Tax Torpedo

Photo credit: ©iStock.com/Inside Creative House, ©iStock.com/ljubaphoto, ©iStock.com/smartstock