Social Security Taxes Can Hit You Hard in Retirement. Here’s How to Lower Them (2024)

Retirement account withdrawals not only help you cover basic living expenses, but they also can fund the lifestyle you’ve always envisioned in your golden years.

That money, however, can have unintended tax consequences. Required minimum distributions (RMDs) and other withdrawals can leave you paying higher taxes on your Social Security benefits, and in turn, expose you to higher marginal tax rates, according to a new analysis from T. Rowe Price.

There are ways to reduce this risk, though. Converting your savings into Roth assets early on is one option, as well as selling off investments with little to no capital gains, according to T. Rowe Price. Here’s a closer look at this tax dilemma and some other ways to work around it.

Is Social Security Taxed?

Yes, there’s a good chance you’ll pay taxes on your Social Security benefits, so it’s essential to first understand how Social Security is taxed.

The IRS relies on what’s called “combined” or “provisional” income to calculate the taxes on a person or a couple’s Social Security benefits. You can calculate your combined income by adding half your annual Social Security benefit to your adjusted gross income and any nontaxable interest you receive.

For example, if you collect $20,000 in Social Security and have another $30,000 in other income, including 401(k) withdrawals, your combined income for the year would be $40,000.

Social Security benefits aren’t taxed if combined income is:

Up to 50% of benefits are taxed if combined income is:

Up to 85% of benefits are taxed if combined income is:

Social Security Taxes Can Raise Your Marginal Tax Rate

While your typical tax planning may revolve around the federal income tax bracket that you’re in, keep in mind that the taxes you pay on Social Security can increase your marginal tax rate well above your tax bracket.

“In some cases, those in the 22% federal tax bracket could end up paying a marginal tax rate as high as 40.7% because additional retirement income causes more of their Social Security income to become taxable,” writes Roger Young, a certified financial planner (CFP) and T. Rowe Price thought leadership director.

T. Rowe Price found that even withdrawing an extra $1,000 from an IRA can have significant tax consequences. The financial services company offered the example of a married couple who collects $70,000 per year in Social Security and has another $65,000 in taxable retirement income. On top of paying $220 in taxes on the extra $1,000 withdrawal, the additional income means the couple would owe taxes on $850 of Social Security benefits that would otherwise go untaxed, T. Rowe Price found.

How to Lower Your Taxes on Social Security

Here are some simple strategies that will potentially help you lower your Social Security tax bill, and in turn, your marginal tax rate.

Use Roth conversions. Executing a Roth conversion has two benefits for people whose retirement income is hiking their marginal tax rate. First, Roth withdrawals aren’t taxed, so they don’t factor into your combined income calculation. Just keep in mind that you’ll have to pay taxes on the money when you complete the conversion.

Second, Roth accounts aren’t subject to RMDs. As a result, T. Rowe Price says converting your pre-tax assets into Roth funds – especially early in retirement – will help reduce your taxable income. With lower RMDs, or none at all, your combined income will be lower, lessening your Social Security tax liability.

Rely on nontaxable income sources. Just as Roth assets can help alleviate this potential tax problem, so can other nontaxable income sources, T. Rowe Price says. That could mean drawing on cash reserves or selling investments that have little or no capital gains. “Having some financial flexibility can also help you limit your highly taxed income,” Young writes. “If you think you could be subject to high marginal rates, you may want to fund additional spending needs with income sources that generate little or no taxable income.”

Take more taxable distributions. While it may seem counterintuitive, T. Rowe Price also says that taking even more taxable distributions in a given year can end up helping you lower your marginal tax rate in future years. “If you’re approaching the point where the maximum 85% of your Social Security benefits are taxable, you could take more taxable distributions once you pass the 85% cap,” Young writes. “That would free up cash to use next year so that you can avoid the high marginal rate in that year.”

Bottom Line

Withdrawing money from retirement accounts can increase the taxes you owe on your Social Security benefits. This problem can lead a retiree in the 22% federal income tax bracket to pay a marginal tax rate as high as 40.7%. But Roth conversions and other nontaxable income sources can help lower your Social Security tax liability, and in turn, your marginal tax rate. If your income is high enough that you owe taxes on close to 85% of your Social Security, you may want to consider withdrawing even more money and taking the tax hit this year. Those extra withdrawals can help fund your needs in the years to come and lower your future tax liability.

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