Way back in 1938 the U.S. Treasury Department ruled that Social Security benefits were excluded from federal income taxes. That ruling held until 1984 when a portion of Social Security benefits were subjected to federal income taxes.
The somewhat mind-boggling rationale for subjecting money we already paid as a form of taxation to yet another tax is embodied in this 1983 Report by the House Ways and Means Committee statement:
“Your Committee believes that social security benefits are in the nature of benefits received under other retirement systems, which are subject to taxation to the extent they exceed a worker’s after-tax contributions and that taxing a portion of social security benefits will improve tax equity by treating more nearly equally all forms of retirement and other income that are designed to replace lost wages. . .”
How The Government Taxes Social Security
In any case, Social Security, which was never meant to be a sole source of most worker’s retirement income, is further eroded by more taxation. Here’s what every retired worker on Social Security has to give back to the government:
If you file a federal tax return as an “individual” (including a spouse filing separately) and a total of one-half your benefits and all your other income is:
- between $25,000 and $34,000, you pay income tax on up to 50 percent of your total benefits for the tax year
- more than $34,000, up to 85% of your benefits may be taxable
If you file a joint return and a total of one-half your benefits and all your other income is:
- between $32,000 and $44,000, you pay income tax on up to 50 percent of your total benefits for the tax year
- more than $44,000, up to 85% of your benefits may be taxable
3 tax strategies to limit the tax impact of Social Security income
The average taxpayer can limit the amount of taxes they pay on retirement benefits in 3 ways:
1. Contribute to a Roth IRA or Roth 401(k)
Those contributions are through money already taxed. Distributions from a Roth IRA are tax-free. The payouts won’t affect taxable income calculations and Roth IRA owners don’t have to withdraw funds based on age or length of time they held the Roth IRA.
2. Dip into Taxable Retirement Income Accounts Before Retirement
Someone still working past age 59½ can begin drawing from a regular IRA, but still have to pay income tax on the amount withdrawn. The strategy is to pay a lesser amount in tax than from Social Security and delay drawing Social Security in favor of higher benefits at a later age.
3. Buy an Annuity Contract
A qualified longevity annuity contract (QLAC) is a tax deferred annuity where contributions are paid from a qualified retirement plan or IRA. QLACs are monthly payments for life and are protected from stock market downturns. They are also exempt from monthly minimum distribution rules until payouts start after the specified annuity starting date. The idea is to limit monthly distributions and thus taxable income.
