Many retirees have seen their Social Security benefits increase in 2023 due to a cost-of-living adjustment that was higher than in past years. Further increases are expected for 2024. While more benefits are welcome, they could mean more income taxes on those benefits for some recipients.

The Social Security Administration (SSA) estimates that more than half of recipient families owe federal income taxes on their benefits. Recipients who have significant income from other sources are particularly at risk. Here’s what you need to know about the taxation of Social Security benefits.

Tax Triggers

The taxability of Social Security benefits depends on your “combined income.” If the only income you received in the tax year was Social Security benefits, they generally aren’t taxable. If you also report income from wages, self-employment income, pensions, interest, ordinary dividends or capital gains distributions, you may owe tax on either 50% or 85% of your benefits.

However, Social Security benefits do have a tax advantage over some other types of retirement plans. While the distributions from those plans may be fully taxable, you won’t pay taxes on more than 85% of your Social Security payments.

Generally, the greater your combined income, the larger the portion of your benefits that will be taxable. Here are the current income ranges at which 50% of your benefits will be subject to federal income tax:

Taxpayers with combined income above these ranges will owe tax on up to 85% of their benefits. Married taxpayers who file separate returns are usually required to pay taxes on their benefits.

Combined income isn’t reduced by any deductions, exclusions or exemptions. It includes the following items:

• Adjusted gross income (AGI),
• Tax-exempt interest (for example, interest on municipal bonds), and
• Half of your Social Security benefits.

Important: Your children’s Social Security dependent or survivor benefits don’t count toward your taxable income.

If you do owe tax on your Social Security benefits, you can make quarterly estimated payments to the IRS or have federal taxes withheld. With the withholding option, you won’t have to pay an annual lump sum or worry about incurring a potential underpayment penalty. Also check with your tax advisor about whether your Social Security benefits will be subject to state income tax.

Income Reduction Strategies

Several strategies could help lower your combined income and, in turn, the amount of your benefits subject to taxation. For example, you can delay taking Social Security benefits by drawing down your tax-deferred retirement accounts first (after reaching age 59½ to avoid early withdrawal penalties). You’ll have to pay ordinary income tax on those withdrawals, but you’ll reduce the account balances, which should translate to smaller required minimum distributions (RMDs) when they kick in at age 73 (or, after 2032, age 75). Delaying your Social Security benefits will mean you get larger payments when you do begin collecting, but only 50% counts toward your combined income, versus 100% of RMDs.

As a bonus, lowering your income could also lead to lower Medicare premiums. Plus, you might leave your heirs with tax-favorable inheritances. That is, money in tax-deferred accounts is taxed to heirs at their ordinary income rates, which may be lower than your tax rate, and dollars in Roth accounts are income-tax-free for your heirs.

You also could make a qualified charitable donation (QCD). IRA owners age 70½ or older can transfer up to $100,000 ($200,000 if both spouses are age 70½ or older and have IRAs) to qualified charities each year. Those donations are excluded from gross income. You also can make a one-time QCD transfer of up to $50,000 through a charitable gift annuity or charitable remainder trust (as opposed to directly to the charity). Donors who are at least age 73 (or, after 2032, age 75) can count their QCDs toward their RMDs for the year.

Another way to lower your combined income is by harvesting tax losses. Under this strategy, you’d sell investments that have lost value to offset any capital gains. If your capital losses exceed your capital gains, you can deduct up to $3,000 ($1,500 for married filing separately) a year from your ordinary income and carry forward any remaining excess indefinitely.

You can enhance the benefit of loss harvesting by donating the proceeds from the sale to charity. You’ll offset realized gains and ordinary income and increase your charitable contribution deduction (subject to AGI limitations on the charitable contribution deduction). However, the latter benefit isn’t available to taxpayers who claim the standard deduction, rather than itemizing.

Proceed with Caution

As with all tax planning, maximizing your Social Security benefits involves various moving parts. Contact us to help devise the optimal strategy to reduce your overall tax obligation for Social Security benefits, retirement account distributions and other sources of income.