Tax rules are complicated enough, and Social Security benefits during retirement years add another layer of complexity. Not knowing how and when Social Security benefits are taxed can lead to an unpleasant surprise when Uncle Sam comes calling, so it’s a good idea to know what to look out for.
How does Social Security affect my overall tax rate?
Half of your Social Security benefits count toward your combined income, which includes your adjusted gross income plus nontaxable interest. If your combined income reaches a certain threshold — $25,000 for an individual and $32,000 for a married couple filing jointly — you’ll have to pay income tax on anywhere from 50% to 85% of your Social Security benefits. The Social Security website has more information on the percentage of benefits taxable.
Why are tax brackets crucial?
It’s important to pay attention to income tax brackets to avoid the Social Security “tax bubble.” This occurs when a retiree’s additional income, such as required minimum distributions from retirement accounts, pushes their overall income past the threshold at which Social Security benefits become taxable. This can result in the additional income being taxed at a marginal rate as high as 46.25%, even though the retiree may ordinarily belong in the 25% or 28% tax bracket.
This situation is called a “bubble” because the triggering of Social Security benefits taxation, and the outsized rise in taxable income that comes with it, is only in play up until the maximum amount of Social Security benefits are taxed, at which point the tax rate returns to normal.
To prevent taking this tax hit, you can delay Social Security or withdraw from retirement accounts before you’re required to, so you can mitigate the impact of withdrawals in future years.
What else should people be aware of when it comes to retirement and tax brackets?
People spend their working years trying to defer income as a way to limit taxes. Once you retire, though, you may want to add income to maximize the 15% federal tax bracket through Roth IRA conversions or capital gains.
Adding income in this way could potentially reduce your tax obligation in the future, since withdrawals from Roth IRAs are tax-free. Once you reach age 70½, the required minimum distributions from your retirement accounts could push you into the 25%, 28% or even 33% tax brackets, unless you take steps to lower your taxable income.
That’s why it’s important to do tax planning each year to determine what is optimal in your situation. You don’t want to be hit with a large tax bill when you can least afford it.
Anything else to keep in mind?
Social Security taxation, Roth IRA conversions and related strategies are complex and confusing, and poor tax planning could result in thousands of dollars in additional taxes. I highly recommend working with a professional to help you make smart financial decisions.
This article originally appeared on NerdWallet.com.
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