Taxes on Social Security: 2 ways to save

Learn how you can help reduce your taxable income in retirement.

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Key takeaways

  • You may end up paying taxes on your Social Security benefits, depending on your household income.
  • One key to reducing your tax burden in retirement is to reduce your taxable income, and there are strategies available to do that.
  • If you can delay receiving your Social Security benefits and qualify for a partial Roth conversion, you may be able reduce the amount of taxes you pay in retirement.

You work at your job, you pay taxes, then when you retire, you get Social Security benefits tax-free, right?

Wrong. Up to 85% of the Social Security benefits you get each year could be subject to tax, depending on your household income.

What’s more, 100% of your withdrawals from traditional IRAs and traditional 401(k)s will likely be considered taxable income.

There are ways to keep more of your retirement income—but first, it helps to understand how retirement income is taxed.

Taxes on retirement income

In retirement, different kinds of income are taxed differently:

  • 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.
  • Distributions from traditional 401(k)s and IRAs are typically subject to the tax rates associated with your current marginal tax bracket.
  • Dividends paid or gains from the sale of stocks are taxed at 0%, 15%, or 20%, depending on how long you've held the stock, your taxable income, and your tax filing status.
  • Other income—such as qualified withdrawals from a Roth IRA, a Roth 401(k), or a health savings account (HSA)—are not subject to federal income taxation and do not factor into how your Social Security benefit is taxed.1

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 can be taxed. (Not to worry: Your Social Security benefits can’t be taxed more than 85%.)

So as you work with financial and tax professionals, consider the following 2 strategies. (Note that if your and your spouse’s combined annual retirement income is more than $100,000, you will likely need additional tax planning.)

1. Converting savings into a Roth IRA

"One strategy to reduce the taxes you pay on your Social Security income involves converting traditional 401(k) or IRA savings into a Roth IRA," says Shailendra Kumar, director at Fidelity's Financial Solutions.

Not everyone can contribute to a Roth IRA or Roth 401(k) because of IRS-imposed income limits, but 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 into a Roth IRA. This process of converting some of your IRA or 401(k) into a Roth IRA 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-free,2 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.”

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 professional for help.

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

2. Delaying your Social Security benefit claim

"The other strategy,” says Kumar, “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."

Consider a hypothetical couple named Natalie and Juan: For every year they delay taking Social Security past their full retirement age (FRA), they get up to an 8% increase in their annual benefit.

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

Natalie and Juan’s 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 them because by delaying claiming Social Security until age 70, the percentage of their Social Security income that gets taxed is cut from 85% to 48.33%.

It gets better: While Natalie and Juan’s retirement paycheck of $70,000 remains the same, they pay approximately 37% 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.

Tip: To learn more about timing and Social Security, read Viewpoints on Should you take Social Security at 62?

Planning ahead

As you develop short- and long-term retirement income strategies, remember:

  • In general, the more money coming from your traditional pre-tax IRA, 401(k), or 403(b) to fund spending in retirement, the more tax you’ll likely pay.
  • Conversely, in general, the greater the overall percentage of your retirement income coming from your Social Security income, the less tax you’ll likely pay over time.

"As the only inflation-protected source of lifetime income for many people, your Social Security benefit is of great value,” says Kumar. “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 ways to combine guaranteed retirement income with flexible income sources.

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