Avoid the Social Security Tax Trap

Calculating Your Income Level

Filers in either of the first two categories must compute their provisional income—also known as modified adjusted gross income (MAGI). That requires adding together tax-exempt interest (such as municipal bond interest), 50% of the year’s Social Security income, and any other tax-free fringe benefits and exclusions to adjusted gross income, and then subtracting adjustments to income (other than education-related and domestic activities deductions).

Example 1

Jim is single. He earned $19,500 for the year and received $2,000 of interest income and $1,500 from gambling winnings. He also receives $10,000 in Social Security income. ($19,500 + $2,000 + $1,500 + $5,000 = $28,000)

Jim’s provisional income will come to $28,000. He may thus have to pay taxes on up to 50% of his Social Security benefits.

Example 2

Henry and Sharon Hill have joint earned income of $48,000, plus $4,000 of interest and $3,000 of dividends. Their Social Security benefits come to $20,000:

$48,000 + $4,000 + $3,000 + $10,000 = $65,000

Their MAGI is $65,000. They may have to pay tax on up to 85% of their Social Security benefits.

Related IRS Forms and Publications

You can use IRS Publication 915 to estimate the amount of taxable Social Security income you will have. Qualified plan participants who also contributed to a deductible IRA must use the worksheets found in IRS Publication 590-A instead.

For those who filed as Married Filing Separately and lived at any time with a spouse during the year, IRS Publication 915 states that up to 85% of your Social Security may be taxable regardless of the sum.

How to Lower Your Social Security Taxes

There are several remedies for those who are taxed on their Social Security benefits. Perhaps the most obvious solution is to reduce or eliminate the interest and dividend income in the provisional income formula. In both of the examples shown above, the taxpayers would have reduced their Social Security tax if they hadn’t had declarable investment revenues on top of their other income.

The solution could be to convert the reportable investment income into tax-deferred income, such as an annuity, which will not show up on a Form 1040 until it is withdrawn.

If you have $200,000 in certificates of deposit (CDs) earning 3%, which translates into $6,000 a year, that will be counted as provisional income. But the same $200,000 growing inside an annuity, with the interest reinvested back into the annuity, will effectively yield a reportable interest of $0 when computing provisional income.

Generally, annuities become taxable income when they are taken as distributions, depending on the account type. Virtually any investor who is not spending all of the interest paid from a CD or other taxable instrument can thus benefit from moving at least a portion of assets into a tax-deferred investment or account.

Earmarking Retirement Accounts

Another possible remedy could be to earn a little less if you are at or near the income threshold for the tax on benefits. In the first example listed above, if Jim were to move his taxable investments into an annuity and earn $1,000 less, he would have virtually no taxable benefits.

Shifting investments from taxable accounts into a traditional or Roth IRA will accomplish the same objective, provided funding limits have not been surpassed.

IRA Contribution Limits

The IRS has established contribution limits for contributing new money into an IRA.

The annual contribution limit to both a traditional IRA and a Roth IRA is $6,500 per year for 2023, and $7,000 for 2024. People age 50 and over can deposit a catch-up contribution of $1,000 per year for both years.

The contribution limit for a 401(k) is $22,500 for 2023 and $23,000 for 2024. If you are 50 or older, you can contribute an additional $7,500 as a catch-up contribution in 2023, and 2024. 

Under the SECURE 2.0 Act of 2022, the maximum catch-up contribution limits will be indexed to inflation starting in 2024.

IRA Distributions

Keep in mind that you can take distributions penalty-free after age 59½. You definitely want to avoid paying the 10% penalty for an early withdrawal.

Since any withdrawals on a traditional IRA (but not a Roth IRA) are taxable, they must be planned carefully while considering the other income taxes you will owe for the year. The goal is to pay less in tax by making more withdrawals during this pre-Social Security (but after age 59½) period than you would after you begin to draw benefits. That requires considering the total tax bite from withdrawals, Social Security benefits, and any other sources.

Be mindful, too, that at age 72 (or age 73 starting in 2023), you need to take required minimum distributions (RMDs) from these accounts, so you need to plan the income hit based on those mandatory withdrawals.

The Bottom Line

There are many rules concerning the taxability of Social Security benefits, and this article attempts to cover only the major rules and issues related to this topic. For more information on this topic, visit the IRS website and download IRS Publication 915 or consult a tax advisor.