The Social Security Tax Trap
Retirees face multiple income traps. Many will see a portion of their Social Security income make its way onto the taxable income line of their 1040s.
Those who convert their traditional IRAs to Roth IRAs are especially susceptible to this situation. If you exceed the funding limit, the extra income pushes you beyond the income threshold level. As a result, you pay tax on Social Security income.
Additionally, a change in marital status for any reason can place you in a higher tax bracket.
Rising income means lower- and middle-income retirees are hit by the so-called tax torpedo, as rising income means Social Security benefits are taxed.
After a one-year hiatus, RMDs will be back when filing 2021 taxes. As a result, your income increases.
Avoiding the Social Security Tax Trap
- Seniors can take steps to avoid or minimize tax traps. These include delaying spending from one year to the next, Another strategy is to judiciously tap after-tax accounts to lower taxable income.
- Another option would be taking RMDs as a qualified charitable distribution if you don’t need the income. That way, it won’t trigger higher taxes or higher future Medicare premiums.
- Retirees in their 60s often pay little or no taxes before receiving Social Security. Many are living off after-tax savings, Roth IRA accounts, or inherited money. The standard advice is to first spend this money. Next, use money in tax-deferred accounts. Then, take advantage of the low tax bracket and convert money in tax-deferred accounts to Roth IRAs.
- Generally, annuities become taxable income when they’re taken as distributions depending on the account type. Virtually any investor who isn’t spending all the interest paid from a CD or other taxable instrument can benefit from moving at least a portion of his or her assets into a tax-deferred investment or account.
- Another remedy is to simply work a little less. This is especially true if you’re at or near the threshold of having your benefits taxed.
There are many rules concerning the taxation of income during retirement. Make sure you understand your situation to find ways to minimize the impact.