Your “provisional income”—that is your Adjusted Gross Income (AGI)—is what determines whether or not your Social Security benefits will be taxed. Your AGI is considered to be your income (excluding Social Security benefits) plus non-taxable interest and half of your Social Security benefits. Are we confused yet?
Kiplinger’s recent article, “5 Ways to Avoid Taxes on Your Social Security Benefits,” explains that if it's below $25,000 and you file taxes as single or head of household (or less than $32,000 if you file a joint return), you won't owe taxes on your benefits. So if your provisional income is between $25,000 and $34,000 and you're single, or between $32,000 and $44,000 if you file jointly, it means that up to 50% of your benefits may be taxable. If your provisional income is more than $34,000 for a single or more than $44,000 if married filing jointly, up to 85% of your Social Security benefits may be taxable.
Here are a few strategies that can help you keep your income below the thresholds and decrease the part of your benefits subject to tax.
Donate your RMD to charity. Those who are 70½ or older can give up to $100,000 annually to charity from their IRAs tax-free. This gift counts as the required minimum distribution (RMD) but isn’t included in adjusted gross income.
Purchase a QLAC. You can invest up to $125,000 from your IRA or 401(k) in a special version of a deferred-income annuity known as a Qualified Longevity Annuity Contract (QLAC). Money in a QLAC isn’t considered in calculating your RMD. As a result, you can reduce the size of your RMD, lower your income and decrease your tax bill. Payouts don’t start for several years. It can be as late as age 85 when they’ll be included in your taxable income.
Withdraw money from tax-free Roth IRAs. Tax-free withdrawals from a Roth IRA or Roth 401(k) aren’t calculated as part of your AGI. If you roll over money from a traditional IRA or 401(k) to a Roth prior to receiving Social Security benefits, you can avoid taxes later in retirement. You are required to pay income taxes in the year of the conversion, but you can use the funds tax-free after that.
Review income investments. Structure your portfolio to minimize the income it generates when that income is being reinvested because you're recognizing income you don't need. This means taxes you don't want to pay! Consider a growth-oriented portfolio and remember that nontaxable interest, like interest on municipal bonds, is included when calculating the taxes on your Social Security benefits.
Look at your entire tax situation. If your income in retirement is more than $44,000, there may simply not be anything you can do to get yourself under that level. In that case, look instead into the overall tax efficiency of your assets to see if there are other areas where your tax liability might be minimized.
Reference: Kiplinger (July 2016) “5 Ways to Avoid Taxes on Your Social Security Benefits”