It’s bad enough that you have to pay Social Security taxes while you’re working. Even worse: You might be taxed on Social Security benefits you receive in retirement!
Strategy: If it looks like you’ll incur taxes on Social Security benefits, you might make some moves to reduce your tax liability.
Here’s the whole story: Whether or not you must pay tax on Social Security benefits depends on the amount of your “provisional income” (PI).
For this purpose, PI is the total of your AGI, tax-exempt interest income and one-half of the Social Security benefits received.
For example, if your AGI is $80,000 and you collect $12,000 in municipal bond income and $16,000 in Social Security benefits, your PI for the year is $100,000 ($80,000 + $12,000 + $8,000).
There are two tiers for taxing Social Security benefits.
Tier 1: If your PI is between $32,000 and $44,000 ($25,000 and $34,000 for single filers), you must pay tax on the lesser of one-half of your benefits or 50% of the amount by which PI exceeds $32,000 ($25,000 for single filers).
Tier 2: If your PI is above $44,000 ($34,000 for single filers), you must include in taxable income 85% of the amount by which PI exceeds $44,000 ($34,000 for single filers) plus the lesser of the amount determined under the first tier or $6,000 ($4,500 for single filers). However, the taxable amount cannot exceed 85% of your benefits.
The tier thresholds aren’t indexed for inflation, so more retirees have to face the tax consequences on benefits every year.
Example: Let’s say you’re retired and file a joint return. You are entitled to a taxable pension of $20,000; taxable interest, dividends, and capital gains of $14,000; tax-exempt interest of $6,000; and Social Security benefits of $16,000. Based on these amounts, your PI is $48,000 ($20,000 + $14,000 + $6,000 + $8,000).
Because your PI exceeds the $44,000 level, you’re taxed on $9,400 of your Social Security benefits—$6,000 from the first tier (the lesser of $8,000 or $6,000) + $3,400 from the second tier (85% of $4,000).
The calculation is as follows:
A. 85% of excess PI over $44,000 (Tier 2) = $3,400
B. Lesser of one-half benefits or 50% of excess PI over $32,000 (Tier 1) = $8,000
D. Total tax (A + the lesser of B or C) = $9,400
4 ways to trim your tax bill
The trick for reducing the tax is to knock down your PI below one or both of the tier thresholds.
- Cash in on stock market losers. The capital losses you realize before the end of the year can offset capital gains plus up to $3,000 of ordinary income. This may be enough to pull down your PI to a lower level.
- Redeem bank certificates of deposit (CDs) to pay for living expenses. The CDs produce annual income that will increase your AGI.
- Defer taxable income to next year. For example, if you plan on investing CDs or T-Bills, make sure you acquire investments that won’t mature until 2014 or later.
- Double up on IRA liquidations. If you have to tap your IRA for living expenses, take a double distribution in 2013. If you aren’t required to take withdrawals each year, you could live off the proceeds without taking taxable funds from your IRA next year. This could result in less tax in alternate years.
Tip: To figure out your tax, use the work sheet in IRS Pub. 915, Social Security Benefits and Equivalent Railroad Retirement Benefits.
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