Here's some good news: Your Social Security payment is about to go up next year. Here's the bad news: Your tax bill may rise along with it.
The annual increase to the Social Security payments, called the cost-of-living adjustment, or COLA, is typically announced in October. This year's increase is more modest than last year's, but it could help ease the pain of continuing inflation for many retirees struggling with rising costs for everything from gas to groceries.
The COLA can be a helpful boost to your retirement income when inflation is running high. But the increase may also call for some additional tax planning. Here's why, plus some tips on how to manage the potential consequences of this upcoming raise.
Higher expenses, higher income, higher taxes
Even on its own, the extra COLA money could bump some people into a higher tax bracket. But with inflation still running high, many retirees may not be able to fully cover higher expenses with the COLA alone, and may also need to increase their withdrawals from retirement accounts. Depending on which accounts they draw from, these extra withdrawals could further increase their combined income, known as "provisional income," which is the income measure that determines taxation of Social Security benefits.
"The more money you withdraw, the higher your combined income will be, and the bigger portion of your Social Security benefit will be taxed as ordinary income," says Can Lu, director of financial solutions at Fidelity.
If you're facing these circumstances, don't fret. There are ways designed to plan for the tax increase and to help keep more of your retirement income next year.
How might the COLA affect your taxes?
It might first be helpful to understand more about the COLA, and how different sources of income, including your Social Security, are taxed in retirement.
The COLA, which was introduced during the high-inflation decade of the 1970s, is usually approved in December and goes into effect in January of the next year. Last year's increase of 8.7%, one of the highest in decades, was approved when inflation was much higher than it has been throughout 2023. Inflation has decreased this year. The Consumer Price Index for all Urban Wage Earners and Clerical Workers, or CPI-W, the inflation gauge used to determine each year's COLA, has increased by 3.4% during the 12 months through August 2023.
An individual's Social Security income is taxed based on a combined income formula.
That includes typical forms of income such as wages, interest, dividends, pension payments, and taxable distributions from traditional 401(k)s and IRAs (less adjustments), as well as nontaxable interest and half of Social Security benefits. If your combined income is above $34,000 for a single person or $44,000 for a couple, up to 85% of your benefit could be taxed. (Below these thresholds, a smaller percentage of your benefit is taxed.)
Read Viewpoints on Fidelity.com: Taxes on Social Security: 2 ways to save
For example, assume that in 2023 a retiree has $57,000 in expenses. To cover them, they withdraw $37,807 from a traditional IRA while receiving $24,000 in Social Security benefits, paying $4,807 in taxes. Under the formula, 75% of their Social Security benefits are taxed.
In 2024, due to inflation, let's assume the person's expenses increase by 5% and they receive $768 more in Social Security for the year from the COLA. They would need to withdraw $40,413 from their IRA to meet after-tax spending needs, causing the taxable portion of their Social Security benefit to jump to 83%, and the amount paid in taxes would increase by about $524.1
Important to know
Strategies designed to help manage the tax impact
While that's not a huge amount, no one wants to pay more than they must. Here are some strategies you and your tax professional may want to consider that might help lower your provisional income for the year:
- First, consider distributions from a brokerage account where gains figure into provisional income, but basis does not. Additionally, long-term capital gains are taxed at a lower capital gains tax rate, generally between 0% and 20%, if you held the investments over a year.
- Next, attempt to minimize taxable traditional 401(k) or IRA withdrawals, as these are taxed as ordinary income, corresponding to your marginal tax bracket. (That said, be sure to still withdraw enough to meet any required minimum distributions.)
- Finally, consider qualified withdrawals from a Roth IRA, a Roth 401(k), or a health savings account (HSA), which would not be subject to federal income tax and wouldn't have an impact on how your Social Security benefit is taxed. (Note: Roth IRA distributions of earnings must meet the 5-year aging requirement to be tax-free, and HSA withdrawals are only tax-free when used to pay for qualified health expenses.)
Figuring out withdrawals from retirement and brokerage accounts can be complicated, so it may help to work with an advisor. But even if you do it yourself, try to withdraw from your Roth and HSA accounts last, so you can allow those assets longer tax-free growth potential. Withdrawals from all 3 types of accounts in the same year can help with the management of combined taxable income.
Should you start collecting your Social Security benefit now?
It can be tempting to start collecting your Social Security benefit as soon as you're eligible. And considering the larger-than-average COLA in 2023, some people may also wonder whether claiming sooner makes more financial sense. The simple answer is probably not. Even with the high COLA, waiting until your full retirement age (FRA) of 67 may be a more cost-effective strategy. And for every year you delay claiming Social Security past your FRA up to age 70, you get an 8% increase in your benefit.
Recent high inflation is a good reminder that having a portion of retirement income in an inflation-protected, lifetime source such as Social Security is valuable. Delaying Social Security can be an effective way to increase your lifetime benefit.
Keep a long-term planning perspective
The COLA for 2024 can help you keep up with higher costs. And in the short run, managing your withdrawals may help you smooth out the tax bumps during a period of high inflation. Long term, however, your tax planning should be multi-year and more strategic. "You want to take a long view and manage your taxes holistically, not just for this year," Lu says.
Whether you're planning for the next year or the next decade, managing taxes throughout retirement can be complicated. Be sure to work with a tax professional to help you understand the potential tax impacts of any planning decisions.