Can you really do some proactive things to reduce the taxes you pay on your Social Security? Sometimes you can, and we’re going to look at one powerful example.
First, we need to understand the profile of retirees who might be good candidates to reduce the taxes on their Social Security with this strategy. If you show a moderate to low income on your tax return and you are generating a lot of interest and dividends from investments where you don’t need that investment income, you may be able to lower your federal tax bill.
We start by looking at the basic formula from the Internal Revenue Service that determines how much tax you pay on your Social Security. This is called the Provisional Income Formula. You take your modified adjusted gross income, add half of your Social Security and add all of your tax-exempt interest. This total is your provisional income.
As this provisional income gets lower, you pay less tax on your Social Security.
For example, if you’re married, filing a joint return and your provisional income is under $32,000, there’s no tax on your Social Security. If it’s between $32,000 and $44,000, then up to 50% of your Social Security can be taxed. If it’s over $44,000, then up to 85% of your Social Security becomes taxable.
The important key to reducing this tax is to eliminate or shelter the interest and dividends on your tax return from investments that are making your provisional income number higher.
To use a simple illustration, let’s say a 67-year-old couple has provisional income under $32,000. At or below this number, there is no tax on their Social Security.
Let’s assume they get an inheritance from the wife’s mother, and the income on the inherited investments causes their provisional income to go over $44,000, subjecting them to a tax on up to 85% of their Social Security.
Their goal would be to shelter or eliminate the investment income they’re not using to bring their provisional income down. This, in turn, would reduce the tax they pay on their Social Security. Here are three ways they could do that:
First, the couple could reallocate some of the investment money into retirement accounts, if one or both of the spouses have earned income and they qualify. This could be either an IRA or perhaps a small-business retirement plan like a SEP, which would immediately shelter the investment income from taxes.
They could also reallocate some of the investments into tax sheltered annuities, which would shelter the investment income from taxes.
Finally, it might be possible to switch some of the investment money they don’t need for income into certain types of growth stocks that generate less taxable income.
Each of these three strategies would bring the provisional income down. If it’s low enough, it may either reduce the tax on your Social Security or, even better, eliminate it.
This article is for informational purposes only. This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice as individual situations will vary. For specific advice about your situation, please consult with a lawyer, tax or financial professional. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation.