Taxes on Social Security: 2 ways to save

Learn how you can reduce your taxable income in retirement.

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Key takeaways

  • 56% of Americans pay taxes on their Social Security benefit.1
  • In retirement, the tax treatment of Social Security benefits is typically more favorable than the traditional IRA or 401(k) withdrawals, but less favorable than Roth accounts.
  • To keep more of your Social Security income, consider a partial Roth conversion and delaying claiming your Social Security benefit.

If you are approaching retirement and think your Social Security benefit always comes tax-free, you're mistaken. Today, 56% of Americans pay taxes on their Social Security benefit—up from 10% of Social Security recipients in 1984 when the federal government first began taxing the Social Security benefit.

Unless your combined household income in retirement is less than $25,000, then up to 85% of the Social Security benefit you receive each year could be subject to tax. Regardless of your situation, never more than 85% of your Social Security income will be subject to tax. However, 100% of your withdrawals from traditional IRAs and traditional 401(k)s will likely be considered taxable income.

These taxes can really take a bite out of your enjoyment of retirement, so it's important to learn now how Social Security income is taxed and explore ways to help reduce that tax burden.

If you are among the 20% of preretirees whose annual retirement income is in the range of $60,000 to $100,000 per couple, then consider 2 key strategies that can help you reduce the taxes you pay on your Social Security benefit by reducing your taxable income.

"One strategy to reduce the taxes your pay on your Social Security income involves converting traditional 401(k) or IRA savings into a Roth IRA," said Shailendra Kumar, director at Fidelity's Financial Solutions. "The other involves postponing when you first take Social Security. Both approaches can help shave dollars off your tax bill in retirement every year—it just takes a little forward planning."

How the Social Security benefit is taxed

In retirement, different kinds of income are taxed differently. For example, most interest on bank deposit accounts, such as CDs or checking and savings accounts, is taxed at the same federal income tax rate as the money you receive from paid work, known as earned income. Distributions from traditional 401(k)s and IRAs are typically subject to the tax rates associated with your current marginal tax bracket. Other income—such as qualified withdrawals from a Roth IRA, a Roth 401(k), or health savings account (HSA)—are not subject to federal income taxation and do not factor into how your Social Security benefit is taxed.2

When the total income calculated under the combined income formula for social security is more than the threshold ($34,000 for singles and $44,000 for couples), up to 85 cents of every Social Security income dollar will be taxed.

Generally, unless you have annual preretirement income over $100,000—where additional tax planning strategies could be utilized—you should consider the following 2 strategies as you work with your financial and tax advisors to reduce taxes on your combined income in retirement.

Consider a Roth conversion to help boost your after-tax benefit

Although not everyone can contribute to a Roth IRA or Roth 401(k) because of IRS-imposed income limits, you still may be able to benefit from a Roth IRA's tax-free growth potential and tax-free withdrawals by converting existing money from a traditional IRA or a workplace retirement savings account to a Roth IRA account. This process of converting some of your IRA or 401(k) to a Roth IRA account is known as a partial Roth conversion.

"You can choose to convert as much or as little as you want of your eligible traditional IRAs. This flexibility enables you to manage the tax cost of your conversion," adds Kumar. "A Roth IRA or Roth 401(k) can help you save on taxes in retirement. Not only are withdrawals potentially tax-free3, they won't impact the taxation of your Social Security benefit. This is an important aspect of a Roth account that most people are not aware of," he adds.

Remember: The amount you convert is generally considered taxable income. So you may want to consider converting only the amount that could bring you to the top of your current federal income tax bracket. You also may want to consider basing your conversion amount on the tax liability you may incur, so you can pay your taxes with cash from a nonretirement account. Consult a tax advisor for help.

Tip: To learn more about Roth conversions, read Viewpoints on Answers to common Roth conversion questions

Consider delaying your Social Security benefit claim

Even if you don't have a Roth account, there’s another way for individuals or couples to reduce their combined income in retirement: Delay claiming your Social Security benefit.

For every year you delay past your full retirement age (FRA), you get up to an 8% increase in your annual benefit.

In general, many people would benefit from waiting to age 70 to take payments. Others may need the income sooner and may lack the resources necessary to meet expenses during the delay period, or may not live long enough to reap the rewards of delaying their claim.

Let's examine the effect of taxes on a hypothetical married couple, Natalie and Juan, and how they can reduce their tax burden if they both delay claiming their Social Security benefit until each of them reaches age 70 (see chart).

Their strategy is to reduce the amount they withdraw from their taxable IRAs over time and make up the difference in income by waiting until age 70 to claim Social Security. This has a big payoff for Natalie and Juan because by delaying claiming Social Security until age 70, the percentage of their Social Security income that gets taxed is cut from 85% to 50%.

It gets better: Their retirement paycheck of nearly $67,000 per year remains about the same, but they pay 20% less in taxes and withdraw smaller amounts from their respective IRAs each year.

Bottom line: Social Security income becomes even more valuable for retirees when they realize that it is taxed less in retirement versus other forms of retirement income. Consider how long you may live, your financial capacity to defer benefits, and the positive impact the claiming decision may have on taxes you'll pay throughout your retirement.

Plan ahead

As you develop short- and long-term retirement income strategies, remember: In general, the more money coming from your traditional pre-tax IRA or 401(k)/403(b) to fund your spending in retirement, the more tax you will likely pay. Conversely, in general, the greater the overall percentage of your retirement income coming from your Social Security income, the less tax you will likely pay over time.

"For certain segments of retirees, considering a partial Roth conversion and delaying Social Security can be steps to helping reduce the amount of taxes paid throughout retirement," says Kumar. "As the only inflation-protected source of lifetime income for many people, your Social Security benefit is of great value. Understanding the favorable tax treatment of your Social Security over time is an important element in your overall financial planning and retirement security."

Tip: As you approach retirement, think about increasing your contributions to these preretirement savings vehicles such as Roth IRAs. These accounts are federally tax-advantaged, and can help reduce your combined taxable income. This approach makes it possible to help reduce the taxes you pay on your Social Security benefit because you will likely have to withdraw less from traditional taxable IRAs to fund your retirement.

Next steps to consider

See how we can help you grow and protect what matters most.

See ways to combine guaranteed retirement income with flexible income sources.

Explore options on when and how to take Social Security.

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