Some careful planning may reduce or even eliminate the taxes on your Social Security benefits. To determine this tax, you must first calculate your “provisional income,” which is the total of:
Adjusted gross income (AGI) as reported on your federal income tax return;
Tax-exempt interest income from municipal bonds and municipal bond funds; and
One-half of your annual Social Security benefits.
For example, with AGI of $20,000, tax-exempt income of $2,000, and $12,000 in annual Social Security benefits, your provisional income is $20,000 + $2,000 + $6,000 = $28,000.
On a joint return, you can have provisional income up to $32,000 without having to pay any tax on your benefits; for single filers the threshold is $25,000. Over those amounts, up to 50 percent of your benefits can be taxed. If your provisional income is greater than $44,000 on a joint return or $34,000 filing singly, up to 85 percent of your benefits will be taxed.
Thus, if your provisional income is under $25,000 ($32,000 on a joint return), you won’t owe taxes on your Social Security benefits. If that income is well over $50,000, there may not be much you can do to avoid paying tax on 85 percent of your benefits. However, if your income falls within that range, some tactics may cut the tax you’ll pay on your Social Security benefits:
Invest through deferred annuities or permanent life insurance. Either way, your earnings can build up without swelling your AGI. (Try to minimize sales commissions and avoid surrender fees, though.)
Borrow for retirement income. Possibilities include a home equity line of credit, a margin account, a reverse mortgage, a life insurance policy loan, or investment property that you refinance. No matter how you borrow, you’ll receive cash flow but you won’t boost your taxable income.
Sell some stocks. Take losses on depreciated stocks and stock funds to raise cash. Not only will you avoid boosting your taxable income, you’ll also harvest tax deductions that you can use, now or in the future.
Alternate high-income years. If you’re withdrawing from your IRA or liquidating appreciated investments for retirement income, take twice as much as you’ll need, every other year. You might, for example, increase your withdrawals and sales in 2003, boosting your tax bill for that year. In 2004, though, you can use this pool of cash for income while avoiding further withdrawals and sales, thus keeping your income to low levels and minimizing the tax on your Social Security benefits.
