Social Security can play a critical role in your retirement budget. Sixty percent of retirees said Social Security is a major source of their income in the most recent iteration of an annual Gallup poll. Another 28% said it was at least a minor source. Either way, you'll want to make the most of your Social Security benefits if you can.
But one thing that can trip up a lot of retirees is not properly planning ahead. Getting your finances in order before you claim Social Security is essential if you want to get the most out of the government program. And planning goes well beyond deciding what age to apply for benefits .
There's a big thing you need to consider before you claim benefits.
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How the government taxes Social Security
To determine income taxes on Social Security , the IRS uses a special metric called combined income to calculate the portion of your benefits, if any, that are taxable income in any given year. Combined income is equal to half your Social Security benefits, plus your adjusted gross income , plus any non-taxable interest income. If your combined income exceeds a certain threshold, a portion of your Social Security benefits becomes taxable up to 85%.
Here are the thresholds:
| Percentage Taxable | Individual Filer | Joint Filer |
|---|
| 0% | Less than $25,00 | Less than $32,00 |
| Up to 50% | $25,000 to $34,000 | $32,000 to $44,000 |
| Up to 85% | More than $34,000 | More than $44,000 |
Data source: Social Security Administration.
You may notice those thresholds are extremely low. That's because they haven't been updated for inflation in over 30 years, and there's no plan to update them in the future. As a result, taxes on Social Security benefits are becoming harder and harder to avoid.
It's important to note that withdrawals from traditional IRAs , 401(k)s , and other pre-tax retirement accounts will count toward your combined income. So will capital gains on the sale of investments, even if they're subject to the 0% federal income tax rate on long-term gains. However, withdrawals from a Roth account will not count toward your combined income, which can be great for those who plan ahead.
Avoid paying extra taxes in retirement
Social Security taxes become a significant expense when your spending requirements push you to withdraw enough to push more and more of your Social Security benefits into taxable territory. At its worst, an extra dollar withdrawn from your traditional retirement account could result in an additional $1.85 of taxable income. If you're in the 22% tax bracket, you're effectively paying over $0.40 in additional taxes for each extra dollar you withdraw from your retirement account.
That's a situation you may be able to avoid, though.
The simplest way to avoid it is by using Roth conversions before you start taking Social Security. If you have a few years in early retirement before claiming Social Security, you can convert some of your traditional retirement assets in an IRA or 401(k) into a Roth IRA. You'll owe taxes on the amount you convert in the year you make the conversion. But then you won't owe any taxes on the assets when you withdraw them. Even better, they won't count toward your adjusted gross income or combined income.
Image source: Getty Images.
As such, it can make sense for retirees to use Roth conversions to fill the 22% tax bracket if they aren't already maxing it out. For example, if you're an individual who needs $70,000 per year in retirement, you can withdraw the entire amount from a traditional IRA and still have room to convert about $45,000 to a Roth IRA at a 22% tax rate, assuming you take the standard deduction.
Taking the tax hit now can save you from taking a much larger tax hit later. You may also want to consider taking capital gains now. Capital gains get a preferred tax rate depending on your income. But if your capital gains increase your combined income above the thresholds, the effective tax rate you end up paying is much higher.
If you plan well in advance of taking Social Security, the big tax challenge can be avoided. Every person's situation is different though. It may be worthwhile to pay for an hour or two of a financial planner's time to determine a proper strategy to mitigate your overall tax bill in retirement well before you claim Social Security.
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