There’s one unseen cost that could eat into your benefits.
Saving for retirement is difficult, and Social Security benefits can help bridge the gap between what you have saved and what you need to live comfortably in your golden years.
However, there is a hidden cost that could reduce your Social Security benefits. And if you live in one of the 12 states, you might not get as much money as you think each month.
What effect do taxes have on your Social Security?
Even after you retire, you may still owe Uncle Sam a portion of your earnings. Not only are 401(k) and traditional IRA withdrawals taxed, but so are Social Security benefits.
You may be required to pay two types of taxes on your benefits: state and federal. Your state taxes will vary depending on where you live, but the majority of states do not tax Social Security benefits. The following states tax your monthly payments:
- State of New Mexico
- Providence, Rhode Island
- West Virginia, Utah, Vermont
You’re not out of the woods yet if you live in a state that doesn’t tax Social Security. You may still owe federal taxes on your benefits regardless of where you live.
Your federal taxes will be calculated using a figure known as your combined income. This is calculated by adding half of your annual benefit to your adjusted gross income. For example, if you receive $20,000 per year from Social Security and $30,000 from your 401(k), your total income would be $10,000 plus $30,000, or $40,000.
The good news is that it is possible to completely avoid federal taxes. However, because the income limits are so low, you’ll need a combined annual income of less than $25,000 (or $32,000 if you’re married) to avoid paying federal taxes on your benefits.
How to Save Money on Taxes in Retirement
In many cases, taxes are an unavoidable expense that workers must budget for in retirement. However, there is one trick that may allow you to reduce your taxes: investing in a Roth IRA.
Roth IRA withdrawals are already tax-free, but this type of account can also help you avoid paying taxes on your Social Security benefits. Withdrawals from a Roth IRA are not included in your total income. So, if the majority of your income comes from a Roth account, you may be able to avoid paying federal taxes entirely.
For example, if you receive a $20,000 annual Social Security benefit and withdraw $30,000 from a 401(k), your combined income is $40,000 per year, which means that up to 85 percent of your benefits will be subject to federal taxes.
Assume you continue to receive $20,000 per year from Social Security but withdraw $30,000 per year from a Roth IRA rather than a 401(k) (k). In this case, your combined income is only $10,000 per year, and you pay no federal taxes on any of your benefits.
Getting the Most Out of Your Social Security Benefits
It’s understandable that not everyone will be able to contribute to a Roth IRA. If you have all of your retirement savings in another type of account or are earning matching contributions through a 401(k), you may be better off sticking with your current retirement account. However, it’s never a bad idea to be aware of your options.
Taxes are an unavoidable part of life for most people, so it’s a good idea to start planning for them now. You can avoid Social Security surprises in retirement by understanding which taxes you may owe and factoring them into your budget.