Avoiding the "Social Security tax trap" can be a simple matter. For those who have (or will have) lower incomes, it's simple enough; if you don't earn over a certain threshold amount, your benefits will not be taxed. But for those who have or will have higher incomes, it takes some planning.
To further complicate things, retirement income planning requires a long-term view. But tax codes and social security rules can change suddenly, and may mess up plans you made years ago. We have to work with what we have, however, so we'll use current laws and rules to make sense of it all.
STEP ONE: FIGURE YOUR "COMBINED INCOME"
Combined Income is the term the IRS uses to describe the income used to test whether your SS benefits may be taxable. This figure is the total of your taxable income plus any tax-free investment income and 50% of your annual SS benefits.
If you are already receiving SS benefits use your current TAXABLE income from your last tax return, plus any income from tax-free funds, bonds, and other investments. True, the income is tax-free, but for the IRS it is used to determine if your social security benefits can be taxed. Do not count social security benefits at this point.
Now take half of your annual SS benefit and add it to the income above. This will give the figure the IRS calls your "combined income".
If you are married and filing jointly, then you must include your wife's income and half his/her SS benefits as well.
If you are married and filing separately, you can stop now. All of your SS benefits will be taxable.
If you are planning for retirement, use the estimated SS payment from the last statement Social Security mailed to you. Get projections of TAXABLE payments from any pensions, annuities, or retirement funds you have (the taxable portion of IRA's, 410k's, and other retirement funds will be less than your gross). Use your current income from investments like CD's, annuities, stock or bond income that is paid to you (even if it is from tax-exempted bonds or fundsthey still count for this calculation). Also include net income from rental properties and any self-employment income or part time income you will claim when you retire.
Now add 50% of your social security benefits to the rest of your income. This is your "combined income" for the social security tax test.
Be careful if you are married and filing jointly. If your spouse is not retired you need to take into account their full income as well. You should also plan ahead for when your spouse will retire.
STEP TWO: FIGURE YOUR STATUS
Once you know your combined income and threshold, planning under the current laws can be pretty easy. Get IRS publication 915 at www.irs.gov/pub/irs-pdf/p915.pdf and work through the samples. There are a few different ways to juggle how much of your benefits are taxable, and you may want to play with how you file or report.
Generally speaking, if your combined income is between $25,000 and $34,000 and you are unmarried and filing alone, 50% of your SS benefits may be taxable. If your combined income is over $34,000, 85% of your SS benefits may be taxable.
If you are married and filing jointly, and your combined income is between $32,000 and $44,000, 50% of your SS benefits may be taxable. If you combined income exceeds $44,000, 85% of your SS benefits may be taxable.
You'll notice I said "may" be taxable. That's because there are some issues that can reduce or eliminate the taxable portion. These issues are uncommon, but you should work through the IRS worksheets to see if they apply to you.
STEP THREE: PLAN
If you are already collecting SS benefits and you are paying taxes on a portion of them, you need to decide whether the extra income from other sources is worth the trade off.
For example, if you have a part-time job that's pushing your income just into the range where your SS benefits become taxable, it might make sense to cut your hours back slightly. On the other hand, the loss of that few hours income might put your budget into a very tight condition. In that case, you might want to get a few extra hours to help offset the tax bite and maintain your income.
If you're receiving 401k or IRA distributions and you have extra cash accumulating in your savings account, you might look into reducing or deferring distributions until a time when you really need the cash. That way your retirement fund continues to grow on tax-deferred basis (or at the least, it will shrink more slowly). You do not HAVE to take 401k distributions until you're 70 years old, so you can put it off for awhile if it suits your needs.
The idea is to reduce your income to where you are comfortable, while reducing your tax bill at the same time. If you can't do that, then augmenting your income with a few extra thousand a year will offset the tax bite.
If you are approaching retirement age and planning, there are a few things that will help in a very big way.
First of all, reduce your debt as much as possible. Using your retirement funds to make installment payments, credit card payments, and mortgage payments is a sure way to make your income needs higher, and force you into a higher income range that will get your SS benefits taxed.
Second of all, prepare for a much lower income in retirement. If you want to remain below the income thresholds to avoid having your SS benefits taxed, you will not be able to afford a fancy car, yearly trips to the Bahamas, and sit-down restaurant meals twice a week. Sure, if you own your home and have no debt a married couple can get by comfortably on the $50,000 a year or so you can get (two full-benefit SS recipients plus some retirement income) and still avoid the tax threshold. But you will not be driving a new BMW and living in a Miami condo. Something's got to give.
Third of all, roll as much income-producing investment as possible into tax-deferred annuities or retirement funds. Distributions of principal from these funds (which you'll be depositing as after-tax income) will not be counted toward the SS benefit tax test, only the tax-deferred interest portion of the funds, and you can draw down the fund at a rate that limits the taxable amounts you receive.
Finally, you might consider an irrevocable trust that handles all your assets and income, and doles out to you (as your personal income) only enough to keep you under the income threshold. In all likelihood the establishment and maintenance of such a trust will cost more than your tax penalty, however. Be very careful about this avenue.
STEP FOUR: WHAT DOES IT MEAN TO YOU?
This is where many people fail. They figure out how to maximize their income and minimize their tax burden, but ignore what it means to their life.
If your SS benefits are taxed, it's often easier to find additional income to cover the taxes than it is to tighten your belt and avoid them.
Capping your earnings from part-time work can cost you a satisfying out-of-the-house activity for part of the year, when you could probably work an extra couple hours a week and cover the tax bite.
And though limiting your expenses in retirement might seem prudent, do you really want to forgo your golf time, gifts to grandchildren, and lunches with the Red Hats when this is the time to enjoy them most?
The decision to avoid SS benefit taxes is a very personal one. If frugality is your goal, then frugality will win out. But don't forget the rest of life.