Can you really do some proactive things to reduce tax on your Social Security?
Sometimes you can, and we’re going to look at one powerful example.
First, we need to understand the ideal profile of a retiree who might be a good candidate to reduce his or her Social Security tax with this strategy.
If you have moderate-to-low income showing on your tax return, and you are generating a lot of taxable interest and dividends from investments where you don’t need that investment income, you might be a good candidate to lower this tax.
We start by looking at a formula from the Internal Revenue Service that is used exclusively to determine how much tax you pay on your Social Security. This is called the Provisional Income Formula. The way it works is you take your modified adjusted gross income, add half of your Social Security, and add all your tax-free income. This total equals your provisional income.
As this provisional income gets lower, you pay less tax on your Social Security. Once below a certain number, you pay zero tax on your Social Security.
For example, if you’re married, filing a joint return and your provisional income is under $32,000, there’s no tax on your Social Security. If it’s between $32,000 and $44,000, then up to 50 percent of your Social Security can be taxed. If it’s over $44,000, then up to 85 percent of your Social Security becomes taxable.
The important key to reducing the tax on your Social Security is to eliminate or shelter the taxable interest and dividends that are being generated on your tax return from investments that are making your provisional income number higher.
To use a simple illustration, let’s say a 67-year-old couple has provisional income that is under $32,000. At or below this number, there is no tax on their Social Security.
Let’s assume they ended up getting an inheritance from the wife’s mother, and the income on the inherited investments causes their provisional income to go over $44,000, subjecting them to a tax on 85 percent of their Social Security.
The goal would be to shelter or eliminate the taxable investment income they really don’t need to bring their provisional income down. That would reduce the tax on their Social Security.
First, the couple could put some of the investment money in retirement accounts, if one of the spouses has earned income. This could be either an IRA or, perhaps, a company retirement plan, which would immediately shelter the investment income from taxes.
We also could put some of the money in tax sheltered annuities, which would shelter the investment income from taxes.
Finally, it might be possible to switch some of the investment money they really don’t need for income into certain types of growth stocks that generate little taxable income.
Each of these three strategies would bring the provisional income down. If it’s low enough, it may either reduce the tax on your Social Security or, even better, eliminate it.
• Mike Piershale, ChFC, is president of Piershale Financial Group. Send financial questions you want answered in this column to Piershale Financial Group, 407 Congress Parkway, Crystal Lake, or email firstname.lastname@example.org.