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How to Help Minimize Your Social Security Income Tax Bite
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You may be able to reduce the tax impact on your social security benefits

Consider taking these steps now to help avoid a shock when you start receiving Social Security income.

From the Merrill Edge Minute e-newsletter.

Key Points

  • Lowering your "provisional income" may help reduce the taxes you pay.
  • If you are working and start taking Social Security income before you reach "full retirement age," you may face a benefit reduction for earned income.
  • Taxable income from investments is counted toward your "provisional income" and can increase what you owe. Consider whether other kinds of holdings may help minimize your taxes.
Today, when so many people decide to keep working well beyond traditional retirement age, income from Social Security often supplements a salary from part-time or full-time employment. Yet as financially advantageous as that combination can be, it could also increase your tax bill—and probably by more than you expect. As much as 85% of Social Security income may be taxable, and that can be a real shock when people collect their first check. So it's important to develop a Social Security and retirement plan strategy.
How much of your Social Security income is taxable depends on a variety of factors, including your marital status and any additional income you earn. But with some preparation—which can include such steps as rebalancing your portfolio or structuring the way you enact certain transactions—you can help minimize this tax liability.

How taxes on Social Security benefits are calculated

Taxes on Social Security retirement benefits are based on what is commonly referred to as your "provisional income":
How provisional income is calculated
After you exceed the defined thresholds (see the chart below), a portion of your Social Security income will be included in your gross income and taxed at your marginal tax rate. So, for example, individuals in the 25% tax bracket could have up to 85% of their Social Security income taxed at 25%. In some cases, the additional gross income may cause the taxpayer to move to a higher tax bracket, as well.
Calculating your Social Security income tax
Source: Congressional Research Service, February 2016

Working in retirement? Remember the benefit reduction for earned income

In a recent survey, more than 80% of workers age 50 and older said it was likely or very likely they would hold some kind of income-generating job after retiring.2 So it's important to consider how that income will affect your Social Security benefits.
The Social Security Administration considers 66 to be retirement age for most baby boomers. If you are working and start taking your Social Security income before you reach that "full retirement age," the amount you can earn is capped after which your earned income reduces your Social Security benefits.
Examining your income sources well in advance of retirement gives you time to adjust your plans if necessary.
If you will not reach your "full retirement age" of 66 in 2016, the annual earned income cap is $15,720, and for every $2 you earn over that limit, the SSA trims $1 off the top of your Social Security benefits. So if you earn $20,000 this year, your Social Security benefits will be reduced by $2,140 ($4,280 ÷ 2)—on top of any income taxes you may have to pay on the remaining benefits.
If you will reach your "full retirement age" of 66 in 2016, and you earn income in the months before you attain that age, the amount by which that income reduces your benefits will be less. For this purpose, the annual earned income cap is $41,880, and for every $3 you earn over that limit, $1 will be taken off the top of your Social Security benefits. So if you earn $45,000 in the months prior to your 66th birthday, your Social Security benefits will be reduced by $1,040 ($3,120 ÷ 3)—on top of any income taxes you may have to pay on the remaining benefits.
Beginning with the month you reach age 66, your earnings no longer reduce your benefits, no matter how much you earn. And, your benefit amount will be recalculated to leave out the months when they were reduced or withheld due to your excess earnings.
There is some good news for married couples: Unlike provisional income, which is used to determine your tax liability on Social Security income, the earnings limitation is based only on an individual's earned income, not on your spouse's earned income. Whether or not you're married, when you reach your full retirement age, the benefit reduction for earned income disappears and you will receive the benefits that had been withheld in the form of higher benefit payments. Read more about benefits for your spouse and see the Social Security Administration's How Work Affects Your Benefits to learn about working while receiving Social Security payments.

Manage your income to limit taxes

As a way of minimizing tax liability, tax planning professionals often advise clients to reduce their provisional income. "When you plan for retirement," says Vinay Navani, CPA with accounting and consulting firm Wilkin & Guttenplan, "you need to think in terms of multiyear projections." For example, if you anticipate a big onetime event such as the sale of a business, you may be better off structuring the sale as a loan to be paid off over several years instead of an all-cash transaction. For sales of large stock positions, consider selling gradually over several years to minimize the impact in any one year.

Choose investment options that reduce taxable income

Another option to help reduce taxes more generally may be to replace an investment that earns taxable income, such as a taxable bond portfolio, with one that produces little or no taxable income. For example, the income from most municipal bonds isn't taxed on your federal return and therefore reduces your taxable income overall.3 But note, such income would increase the amount of your provisional income which impacts the percentage of your Social Security income that is subject to federal income taxes. See How Social Security Fits into Your Retirement Plan and work with a tax professional to find the best solution for your situation.

Know the regulations

If you plan to work past full retirement age, consult a tax advisor to examine the potential tax implications if you were also to receive Social Security income. You can use the worksheets in Internal Revenue Service Publication 915 to help you calculate your tax liability. Also, check whether your state imposes taxes on Social Security benefits. The best chance to reduce taxes comes if you know what to expect and plan accordingly.

Delay collecting Social Security, if possible

Ultimately, the simplest way to reduce your Social Security income tax liability is to delay claiming Social Security benefits. After all, you only pay taxes on income you actually receive. Plus, each month you wait to collect Social Security between age 62 and 70 will boost your eventual monthly Social Security payment. Remember: Just because you can start receiving Social Security benefits doesn't mean it's the best option.

Next Steps

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1 If you are married, filing separately and live with your spouse, up to 85% of your Social Security income is taxable.

2 According to a 2013 survey by Associated Press-NORC Center for Public Affairs Research.

3 Certain investors' income may be subject to the federal Alternative Minimum Tax (AMT), and state and local taxes may also apply.

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