A Social Security “tax torpedo” could be headed your way soon. Here’s how to avoid it

By | December 19, 2023

A senior couple dealing with unexpected Social Security taxes, commonly referred to as the Social Security tax torpedo.

While retirees may be disappointed to discover that taxes don’t end when they leave the workforce, an invisible threat looms behind the U.S. tax code. The Social Security tax torpedo is as destructive as it sounds, blowing up the budgets of unsuspecting retirees eagerly awaiting their first Social Security check. Having a clear understanding of your Social Security taxes can help you avoid this torpedo in retirement. Here’s what you need to know.

A financial advisor can help you create a financial plan to minimize your taxes in your golden years.

What is a Social Security Tax Torpedo?

The Social Security tax torpedo is a spike in taxes that retirees may experience after receiving Social Security income. Specifically, 50% to 85% of your Social Security check may be taxable, depending on your income level and living circumstances. Additionally, your Social Security income can increase your marginal tax rate, meaning the top portion of your income moves into the next tax bracket. As a result, unsuspecting retirees may pay heavier taxes than expected, and their Social Security benefits may provide less financial support than expected.

Implications of tax torpedoes

The government bases your taxes in retirement on your modified adjusted gross income plus any nontaxable interest (usually from municipal bonds) and half of your Social Security benefits. The resulting amount is called your “combined income,” which is subject to different taxes depending on the amount and the filer’s status.

For example, single filers with a combined income of $25,000 to $34,000 pay taxes on 50% of their benefits. Income above this amount results in taxes on 85% of the benefits. Similarly, those who are married and have a joint income between $32,000 and $44,000 will pay taxes on 50% of their benefits. Any amount above that will be taxed on 85% of the benefits.

Remember, the tax torpedo doesn’t mean losing 85% of your Social Security income tax. Instead, you’ll owe your regular income tax rate on 85 cents of every dollar you receive from Social Security. Additionally, your income tax rate is not the same for all your income because of the way tax brackets work. The US tax code imposes progressive taxes on your income, the higher it is.

For example, suppose you are a single filer in 2023 with total taxable income of $50,000 (which puts you in the 22% tax bracket for income above $44,725). Your combined income is $35,000, and you receive $15,000 in Social Security benefits. You exceed the combined income limit of $34,000, which means you pay taxes on 85% of your Social Security benefits.

This situation means you apply your top marginal tax rate (22%) to 85% of your Social Security benefit ($12,750). So your Social Security tax burden is an expense of $2,805. If your combined income was $34,000 or less, only half of your Social Security would be taxed, an expense of $1,650.

How to avoid the Social Security tax torpedo

A senior calculating his taxes to avoid the Social Security tax torpedo.A senior calculating his taxes to avoid the Social Security tax torpedo.

A senior calculating his taxes to avoid the Social Security tax torpedo.

Losing your hard-earned Social Security benefits to Uncle Sam is not a foregone conclusion. Here’s how to avoid Social Security’s tax torpedo while maximizing your financial well-being and quality of life:

Use a Roth IRA

Roth IRAs are retirement accounts where contributions are made with after-tax dollars, meaning you won’t get a tax deduction if you contribute. However, the distributions during retirement are tax-free. As a result, your Roth IRA income does not count toward your taxable income, reducing the chance that you will exceed the threshold that determines whether 50% or 85% of your Social Security benefit will be taxed.

Live in a tax-friendly state

Thirteen states tax your Social Security check, adding to the federal tax burden. As a result, you can save taxes by avoiding residency in the following states:

  • Colorado

  • Connecticut

  • Kansas

  • Minnesota

  • Missouri

  • Montana

  • Nebraska

  • New Mexico

  • North Dakota

  • Rhode Island

  • Utah

  • Vermont

  • Washington

Give your IRA income to charity

Qualified Charitable Distributions (QCDs) allow you to donate money to charity directly from your traditional IRA. The government does not consider the first $100,000 in donations as taxable income. While this will not directly affect your Social Security taxes, it will reduce your overall taxable income, potentially reducing the portion of your Social Security benefits that are subject to tax. Keep in mind that this benefit applies to traditional IRAs only.

Buy a qualified longevity annuity contract (QLAC)

A QLAC is a specialized annuity that provides a guaranteed income stream later in life. You can transfer $130,000 from a traditional IRA or 401(k) to a newly opened QLAC, which will reduce the required minimum distributions (RMDs) you receive from your retirement account. This way, distributions from your 401(k) or IRA won’t increase your annual income as much, easing Social Security taxes.

Your QLAC has a delayed RMD age compared to traditional retirement accounts. Although the government requires RMDs from a 401(k) or IRA at age 73, you can defer distributions from your QLAC until you’re 85. Keep in mind that you will owe taxes on QLAC benefits in the year you receive them.

Compare your income level with tax brackets

Understanding the income thresholds for different tax brackets can help you plan withdrawals from retirement accounts. By staying within the lower tax brackets, you can reduce the tax share of your Social Security benefits.

Delay in Social Security

Taxes on Social Security income may not apply until you receive your benefits. Therefore, delaying Social Security can help you avoid additional taxes until age 60. If you can work or survive on another income until age 70, you reap two benefits: First, you maximize the amount of your Social Security benefit. Second, you avoid paying Social Security taxes. Additionally, living in a traditional IRA or 401(k) during that time will reduce your RMDs, giving you more control over your income level in your 70s.

In short

A senior is surprised by unexpected taxes, known as the Social Security tax torpedo.A senior is surprised by unexpected taxes, commonly known as the Social Security tax torpedo.

A senior is surprised by unexpected taxes, commonly known as the Social Security tax torpedo.

Understanding and proactively addressing the possibility of a Social Security tax torpedo can help you increase your net income during retirement. By taking advantage of tools like Roth IRAs, charitable giving, and QLACs, you can create a tax-efficient retirement.

Additionally, taking into account how your income level compares to tax brackets and considering delaying Social Security can provide further opportunities to optimize your financial well-being and quality of life in retirement. Consulting a financial advisor can be instrumental in tailoring these strategies to your specific circumstances so you can maximize your hard-earned retirement benefits.

Tips to avoid the Social Security tax torpedo

  • Consulting a financial advisor is a crucial step in planning for retirement and avoiding the Social Security tax torpedo because you can receive personalized guidance tailored to your specific financial situation, goals and preferences. 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.

  • By planning during your working years, a tax-advantaged pension becomes more feasible. However, if you’re already retired, you can still reduce your taxes and prepare yourself for a better financial future.

Photo credit: ©iStock.com/Inside Creative House, ©iStock.com/ljubaphoto, ©iStock.com/smartstock

The post How to Avoid the Social Security Tax Torpedo appeared first on SmartReads by SmartAsset.

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