I’m in my first year of required minimum distributions of $36,000, which is causing me to be taxed on my $33,000 in Social Security benefits. What is a good strategy to reduce my RMDs below $25,000 so my Social Security benefits do not become taxable? Would taking a lump sum from my pre-tax IRA and paying the taxes make sense to avoid the yearly taxable event with my Social Security benefits? Would gifting money to my children/grandchildren (thereby reducing the RMD base) have negative tax consequences for my children/grandchildren? Would it have a positive tax benefit for me?
– Laura
This is a great question Laura, and there are a few strategies that might help you reduce the long-term tax bill on your Social Security benefits. Let’s first explore how Social Security income is taxed and then get into the options available to you.
Do you need additional help managing your RMDs or tax liability in retirement? Consider speaking with a financial advisor today.
How Are Social Security Benefits Taxed?
Whether your Social Security income is taxed, and how much of it is taxed, depends on your tax filing status and your other income. The first step is determining your provisional or “combined income,” which is simply the sum of the following three variables:
If you’re single, you would be subject to the following tax thresholds:
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If your combined income is less than $25,000, none of your Social Security benefits are taxed
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If your combined income is between $25,000 and $34,000, up to 50% of your Social Security benefits are taxed
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If your combined income is greater than $34,000, up to 85% of your Social Security benefits are taxed
If you are married and file jointly, the following limits apply:
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If your combined income is less than $32,000, none of your Social Security benefits are taxed
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If your combined income is between $32,000 and $44,000, up to 50% of your Social Security benefits are taxed
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If your combined income is greater than $44,000, up to 85% of your Social Security benefit is taxed
Keep in mind that the 50% and 85% limits are not tax rates. They simply reflect the maximum portion of your Social Security benefits that could be subject to tax. The taxable amount is then added to your other income and the regular income tax rates and brackets are applied. (A financial advisor may be able to help you plan for Social Security, and this free matching tool can help you find an advisor.)
Strategies for Managing Taxes on Your Social Security Benefits
When it comes to your question about reducing your RMD so your benefits aren’t taxable, you’ll want to pay attention to your overall marginal income tax rate and the points at which a greater percentage of your Social Security benefit is taxed.
For example, if you can move yourself into a situation where only 50% of your Social Security is taxed instead of 85%, that could be advantageous. The same is true if you move from 50% to 0%. If you can’t move between those thresholds, there may not be much for you to do.
In your case, assuming that your RMDs are the only income you have aside from Social Security, there are two main strategies that I would consider.
1. Accelerate IRA Income
Let’s assume that you’re already at or near the point where 85% of your Social Security benefits are being taxed. In that case, taking more out of your IRA this year, as you suggested, could be a helpful strategy. You would increase your current tax bill, but you could potentially reduce future RMDs to the point where only up to 50% of your Social Security benefit is taxed in future years.
One way to do that would be to withdraw extra money and use it for whatever you’d like. Maybe there’s a home project that you’d like to tackle, or maybe, as you suggested, you’d like to give money to your children or grandchildren. You wouldn’t get a tax break for the gift, but they wouldn’t face any negative tax consequences either. Just keep the annual gift tax exclusion ($18,000 in 2024) in mind, as well as the lifetime exemption limit ($13.61 million in 2024).
Another option, and potentially the most tax-efficient route, is to convert some of that traditional IRA money to a Roth IRA. The conversion amount would still be taxable as income, but it would reduce future RMDs and get the money into a Roth, where it could grow tax-free and no longer be subject to RMDs.
Any of these strategies would require a close eye on your total taxable income and how it affects your marginal tax rate. If you can do this in a way that reduces the future taxability of your Social Security benefits without pushing you into higher tax brackets now, you could certainly save yourself some money over the long term. (But if you need additional guidance regarding this strategy, a financial advisor may be able to help.)
2. Make Qualified Charitable Distributions
Another option with the potential for a more immediate benefit is to make what’s called a qualified charitable distribution (QCD). This is when you contribute money to an eligible charity directly from an IRA. The charitable contributions both satisfy your RMD requirement and reduce your taxable income, which would reduce the amount of your Social Security benefit that gets taxed.
This is a good strategy to consider if you don’t need the money and there’s one or more charities that you want to support. However, while it will reduce your tax bill, it will still leave you with less money overall than simply paying the taxes you would otherwise owe. (And if you need help with tax planning and strategic giving, consider working with a financial advisor.)
Next Steps
Taxes are always worth considering as part of your financial planning, but they are only one part of the bigger picture. What matters most is that you have the money you need to support the life you want to live.
The strategies above could support those personal goals by reducing your long-term tax bill, making it easier to pay for the things you care about. It’s also possible to take them too far, reducing your tax bill at the cost of not having the money you need when you need it. Keep this all mind as you consider your options moving forward.
Social Security Planning Tips
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A financial advisor can help you plan for Social Security and integrate your benefits into a retirement income plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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Understanding how your claiming age affects your Social Security benefits is vital to making an informed decision about when to start collecting. Remember, waiting until age 70 will increase your benefits by up to 32% while claiming as early as 62 will result in as much as a 30% lifetime benefit reduction. However, the right decision for you may come down to simply how long you expect to live.
Matt Becker, CFP®, is a SmartAsset financial planning columnist and answers reader questions on personal finance and tax topics. Got a question you’d like answered? Email AskAnAdvisor@smartasset.com and your question may be answered in a future column.
Please note that Matt is not a participant in the SmartAdvisor Match platform, and he has been compensated for this article.
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Source: finance.yahoo.com