When you begin to receive social security benefits, if you are still earning income, you may find that they place you in a higher tax bracket. You may also discover that your benefits are reduced due to this additional income.
Adding social security benefits to the income you earn from work, as well as the Required Minimum Distributions (RMDs) from retirement plans, can significantly impact the taxes you pay. If you are not yet at full retirement age, it will also affect your social security income.
The sudden increase in your taxes can be shocking – hitting you like a tax torpedo.
Instead of being caught off guard by the tax torpedo and temporarily losing a portion of your expected benefits, it is better to avoid it altogether. If you are nearing retirement, the sooner you take action, the better.
While the Social Security Administration (SSA) sets limits on how much you can earn from work without losing any social security benefits, you can still receive benefits while working. However, once your income exceeds the limit set by the SSA, a portion or in some cases all of your benefits will be withheld, depending on how much your income exceeds the limit.
Any funds withheld from your social security payments will be repaid to you alongside your regular benefits after you reach full retirement age, providing you with larger monthly checks.
For single individuals, after retiring, if your income exceeds $22,320, every $2 over that amount will result in a $1 reduction in social security benefits. The deducted amount equals 50% of the income over the limit. If your income is significantly above the threshold, you may not receive any benefits for a period of time.
In the year you reach full retirement age, single individuals can earn up to $59,520 in the months leading up to their birthday. During these months, for every $3 over that amount, your benefits will be pre-withheld by $1. After your birthday month, when you hit full retirement age, no benefits will be withheld regardless of how much you earn.
One of the best ways to reduce taxes on retirement accounts (Traditional IRA and 401(k)) is to transfer your funds to a Roth account. A Roth account, whether a Roth IRA or Roth 401(k), allows you to make withdrawals after 59 1/2 without any RMD obligations.
Any funds withdrawn from a Roth account held for at least five years are tax-free. You must pay taxes on the rollover funds but once they are in the account, all growth is tax-free. You can choose to leave it to your heirs if you wish.
Avoid transferring all your funds into a Roth account in the same year. By spreading out rollovers over several years, you can save on taxes rather than facing a hefty tax bill in one year.
Utilizing rollovers can significantly reduce your taxes since you can earn thousands of dollars of interest tax-free. As you have control over any distributions, you can access funds as needed without worrying about tax implications. Even if you have millions in your account, a Roth account can help reduce the tax torpedo, as noted by ThinkAdvisor.
If you make contributions to a Roth IRA, the same limits apply to both traditional and Roth accounts. In 2024, the annual limit is $7,000. If you are over 50, you can contribute an additional $1,000 annually.
The contribution limit for a Roth 401(k) is much higher, allowing you to add up to $23,000 in 2024. If you are over 50, you can contribute an additional $7,500 annually.
If you have not transferred all or any of your retirement funds to a Roth account, keep in mind that you can withdraw from your retirement account after 59 1/2. This will reduce the interest you receive and the amount you must pay when RMDs are due, meaning you pay less in taxes for each RMD. Taking RMDs before applying for social security benefits does not affect your benefits.
Larger RMDs from non-Roth accounts can quickly push you into a higher tax bracket, resulting in paying more in taxes – further reducing your social security benefits. It may also affect your Medicare costs, increasing expenses and potentially losing medical benefits.
Using money from RMDs or withdrawing from a Roth account to sustain your life can allow you to wait until you reach full retirement age (when you can receive full social security benefits) or until you turn 70 (where you can claim 124% of full benefits per month). Waiting will maximize your benefits. You can also supplement income from brokerage accounts, reverse mortgages, savings, or the cash value of life insurance policies.
The SSA allows individuals to prepay a portion of their benefits. You can request the IRS to withhold 7%, 10%, 12%, or 22% of your monthly payments.
Having a Roth account is a key factor in avoiding the tax torpedo. Many employers offer Roth accounts, but not all do. Consult with a financial advisor or estate planner to explore more ways to reduce taxes during retirement.
The original article, “How to Avoid the Social Security Tax Torpedo,” was published on the English version of the “Epoch Times” website.
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