Can you really do some proactive things to reduce tax on your Social Security?
You really can and we’re going to look at one very powerful example. Keep in mind that as with most tax planning strategies, this will not work for everybody, but it will sure work for a whole lot of people if they are in the right situation.
So what is the ideal profile of a retiree who may be a good candidate to reduce his or her Social Security tax with this strategy?
If you have moderate to low income showing on your tax return and you are generating a lot of taxable interest and dividends from investments, where you don't need that investment income, you may be a good candidate to lower this tax.
We start by looking at a formula that the IRS created that is used exclusively to determine how much tax you pay on your Social Security. This is called the "Provisional Income Formula". The way it works is you take your modified adjusted gross income, plus half of your Social Security, plus all your tax-free income and add it together. This equals your provisional income.
And as this provisional income gets lower, you pay less tax on your Social Security and below a certain number, you pay zero 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 your provisional income is between $32,000 and $44,000 and you're married filing joint, then up to 50% of your Social Security can be taxed. And finally if your provisional income is over $44,000 married filing joint, up to 85% of your Social Security becomes taxable.
The important key to reducing the tax on your Social Security is to eliminate or shelter the taxable interest and dividends that are being generated on your tax return from investments that are making your provisional income number higher.
We sometimes call this investment income "Phantom Income" because you're paying tax on income that you're not using. This type of income is found on your tax return on the 1040 on lines 8a, 9a, and line 9b.
To use a simple illustration, let's say we have a 67 year old couple whose provisional income is under $32,000. At or below this number, there is no tax on their Social Security.
Now let's assume they ended up getting an inheritance from the wife's mother and the income on the investments that they inherited causes their provisional income to go over $44,000 subjecting them to tax on 85% of their Social Security.
The goal would be to shelter or eliminate the taxable investment income that they really don't need, to bring their provisional income down, which in turn would reduce the tax on their Social Security.
First, we may be able to put some of the investment money in retirement accounts if one of the spouses has earned income. This could be either an IRA or perhaps a small company retirement plan, which would immediately shelter the investment income from taxes.
We could also put some of the money in tax sheltered annuities, which would also shelter the investment income from taxes.
And finally, it may be possibly to switch some of the investment money that they really don't need for income into certain types of growth stocks that generate very little taxable income.
Each of these three strategies would bring the provisional income down and if they went below $32,000 this couple would be back in the situation where they would not be paying tax on their Social Security.
The key idea is to see if there's phantom income, which is taxable income generated from interest and dividends from investments where you're not really using the money.
Then come up with strategies to shelter that income from taxes which in turn will reduce your provisional income sometimes low enough to either reduce the tax on your Social Security or even better completely eliminate it.
If you're interested in learning more about this and other tax strategies, feel free to call us at 815-455-6453.
The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.