As your first year of retirement progresses, it’s important to evaluate whether the financial plan you put in place to ensure your lasting well-being is going as planned. An appropriate plan should include tax calculations to understand how much of your income will actually be available to you for your needs and wants.
Some people may think it’s a tax-free benefit because you pay Social Security benefits through payroll taxes throughout your life. However, this is often not the case. Both the amount of your Social Security benefits that are subject to taxes and the tax rate itself depend on a number of factors personal to your situation.
To create your own retirement income plan and tax strategy, Talk to a fiduciary financial advisor today.
In short, you may pay taxes on 0%, 50%, or 85% of your Social Security retirement benefits. This depends on your provisional incomealthough:
Provisional income = taxable income + tax-exempt interest + ½ of annual social security benefits
You then compare your preliminary income to that year’s income threshold to determine what portion of your Social Security benefits will be taxed. Your tax rate is your marginal rate. For a single filer, the thresholds for tax year 2023 are as follows:
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For example, if you had $25,000 in 401(k) withdrawals, $5,000 in tax-free bond interest, and $29,000 in annual Social Security benefits, your preliminary income would be:
$25,000 + $5,000 + (½ x $29,000) = $44,500
Because this is above the $34,000 income threshold, 85% of your Social Security income will be taxed.
So almost $25,000 of your Social Security benefits ($29,000 x 0.85 = $24,650) for the year would be taxable in this case. Again, that’s only the amount you have to pay tax on, not the amount you actually pay in tax. The remaining $4,000 or so would be tax-free.
Talk to a financial advisor on developing a strategy to minimize taxes in retirement.
In some cases, it may make sense to reduce your other income streams to avoid additional taxes on your Social Security benefits. Although some advisors may recommend that their clients delay Social Security for as long as possible to receive higher benefits, it may be helpful to reduce tax liability on Social Security income by deferring other income streams instead. For example, you can reduce distributions from a 401(k) or traditional IRA.
This is because any 401(k) or IRA distributions you receive in a year count toward your provisional income, putting you at risk of higher taxes on your Social Security benefits. However, in some cases this trade-off may be worth it, such as if you converted your 401(k) or IRA to a Roth IRA to save taxes in the future. A financial advisor can help you do the calculations to see which strategy might be more beneficial.
If you’re in your 70s, you may already be taking or preparing to take required minimum distributions (RMDs) from your retirement accounts. RMDs will necessarily increase your preliminary income in many cases, but there may be ways to keep this income out of your preliminary income to keep your tax rate on your Social Security benefits low.
For example, you can get ahead of taxes by converting your 401(k) or traditional IRA to a Roth IRA. While this will result in a tax bill up front, it can save even more than just taxes on your Social Security benefits in the long run, since Roth IRA distributions are tax-free. Keep in mind that you often can’t make penalty-free withdrawals from a Roth IRA within five years of opening an account.
Another alternative is to take an RMD as a qualified charitable distribution, or QCD, if you don’t need the money. QCDs are excluded from your taxable income and would not push you to a higher provisional income threshold.
To consider speak to a financial advisor on ways to navigate RMDs within your retirement income plan.
It’s important to plan for Social Security taxes into your overall retirement budget. Keep in mind that the portion of your benefits subject to taxes may change each year, depending on your other income streams. In turn, you’ll want to plan ahead for these considerations each year.
As you plan your golden years, it’s important to get an accurate estimate of how much money you’ll have saved by the time you retire. Fortunately, SmartAsset’s retirement calculator can help you predict how much money you’ll need to retire and whether you’re on track to achieve this goal.
A financial advisor can help you navigate the sometimes complex world of retirement planning. Finding a financial advisor does not have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors serving your area, and you can have a free introductory meeting with your advisors to decide which one you think is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Have an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that is not at risk of significant fluctuations like the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But with a high-interest account, you can earn compound interest. Compare savings accounts from these banks.
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