Pay less tax on the benefits you receive
Don’t expect Uncle Sam to go easy on you once you’re retired. The IRS hits you coming and going. In fact, up to 85 percent of the Social Security retirement benefits you collect could count toward your taxable income.
Advice: Use the four strategies detailed below to lower your provisional income (PI), an awkward tally of various income forms. PI is the total of your:
-Adjusted gross income (AGI) as reported on your tax return.
-Tax-exempt interest income.
-One-half of your Social Security benefits.
Example: If your AGI in retirement is $75,000, municipal bond income is $6,000 and Social Security benefits are $18,000, your PI is $90,000 ($75,000 plus $6,000 plus $9,000).
The higher your PI, the greater the tax bite on your retirement. Conversely, knocking down your PI lets you pay less tax—or even no tax—on Social Security benefits.
Here’s the lowdown:
• You must pay tax on up to 85 percent of your benefits if your PI is above the threshold detailed in the box on page 5.
• Up to half of your benefits are taxable if your joint PI is between $32,000 and $44,000 (between $25,000 and $34,000 for unmarried filers).
• You pay no tax on Social Security income if your joint PI is below $32,000 ($25,000 for unmarried filers).
If your PI is higher than $50,000, you can’t do much to prevent having 85 percent of your benefits taxed.
But if your PI is in the middle range— $32,000 to $44,000 for joint filers, $25,000 to $34,000 for unmarried filers—a little tax planning can work wonders.
4 ways to lower your PI
If you’re in the right circumstance, you can use one or more of these four strategies to reduce your PI.
1. Buy a term annuity. Often, PI-shrinking strategies are most productive before age 701/2. Once you reach that age, you’ll be required to take annual minimum IRA distributions, which might push your PI beyond the tax-planning range.
But, until you reach that age, an immediate annuity can reduce the tax.
Example: Say you retire at age 60 with $300,000 in municipal bonds. Those bonds now yield 5 percent, and you’re counting on that $15,000 in annual income. That $15,000 will count toward your PI when you receive Social Security benefits.
Instead, cash in your bonds and buy a $300,000, 10-year immediate annuity. Your $300,000 will be paid back to you over 10 years, along with interest.
Depending on interest rates, your income might be about $3,500 a month, or $42,000 a year. If you receive $3,500 a month, only $1,000 a month would be taxable, while the other $2,500 will be considered a tax-free return of capital.
Thus, instead of reporting $15,000 in PI from your municipal bonds, you’d have $12,000 a year ($1,000 a month) from the annuity.
2. Borrow money for living expenses. Alternatively, you can support your retirement during your 60s by borrowing against your home, life insurance or securities portfolio. Your AGI won’t increase because none of those maneuvers produce taxable income.
3. Cash in on stock market losses. Liquidate securities for living expenses. If you have some losers in your stock portfolio, for example, sell them off to offset any capital gains you expect to realize. You can deduct up to $3,000 worth of capital losses each year, reducing your AGI and your PI.
4. Double up on IRA withdrawals. What if you must tap your IRA for living expenses during retirement? You might take out two years’ worth of living expenses this year.
Next year, if you aren’t required to take withdrawals, you could live off the proceeds without taking money from your IRA.
That way, every other year, your AGI and PI might fall, giving you a year off from highly taxed Social Security benefits.
How much will you receive?
As you work and pay taxes, you earn Social Security credits. For 2006, you earn one credit for each $970 in earnings, up to a maximum of four credits per year. (The amount of money needed to earn one credit is adjusted annually.)
Most people need 40 credits—or 10 years of work—to qualify for retirement benefits.
Each year, the Social Security Administration (SSA) issues a statement to you regarding your earnings history and an estimate of the retirement, disability and survivors benefits you and your family are to receive.
Advice: Make sure your earnings history is accurate. Report any errors to the SSA because it could affect your future benefits.
Resource: Access the SSA Web site at www.ssa.gov or call (800) 772-1213 for assistance.
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