This post was originally published on this site
Social Security recipients may be in for an unpleasant surprise when they see their benefits are taxed more than usual this year.
Social Security is taxed based on provisional income and a designated threshold, and the more money a retiree brings in, the more likely they are to pay taxes on those benefits. Although Americans continued to live through a pandemic in 2021, there are a few reasons why they may be liable for a higher tax bill, including retiring in that year while receiving benefits or delaying required minimum distributions in the prior year.
Either way, not everyone is prepared, said Mary Johnson, an analyst at the Senior Citizens League.
Retirees may think because they don’t earn a salary anymore that they wouldn’t be subject to taxation on their benefits, said Michelle Gessner, a certified financial planner and founder of Gessner Wealth Strategies.
“Retirees forget that even though they may not have earned income in retirement, they will have taxable income that includes Social Security benefits, interest income, pension income and the distributions they take from their IRAs,” Gessner said. “When all of that adds up, they are often shocked to see that they are not in the lower tax bracket that they had expected – even without earned income.”
About 40% of Social Security recipients pay taxes on their benefits, the Social Security Administration said.
See: Why your Social Security check might be lower
Provisional income is half of a recipient’s Social Security benefits, plus adjusted gross income and income from tax-free interest (such as municipal bonds).
There are limits to how much an individual can receive without paying taxes on benefits – single individuals earning between $25,000 and $34,000 may pay income taxes on up to half of their benefits, and those who earn more than $34,000 could see 85% of their benefits taxable. The thresholds for married filing jointly taxpayers are $32,000 to $44,000 for up to 50% taxed and more than $44,000 for 85%.
Taxpayers who are married but file separately will “probably” pay taxes on benefits, the Social Security Administration said.
Want actionable tips for your retirement savings journey? Read MarketWatch’s “Retirement Hacks” column
The Social Security Trustees’ Report expects roughly $10.6 billion more in tax revenue this year, though that is just an intermediate estimate and the numbers can change. According to the report, taxation of benefits would collect $45.1 billion in 2022, up from $34.5 in 2021.
Retirees could expect to pay more in Social Security taxes if they delayed their required minimum distributions in 2020. As part of a federal relief package, Americans were allowed to waive their RMDs in 2020, which is the amount of money individuals must withdraw from their retirement accounts every year if they haven’t already started to draw down those balances by age 72. If they delayed their 2020 RMD, that means they likely would have had to take out more money in 2021, which could put them at risk of exceeding the threshold.
Many workers also retired in 2021, Johnson said. Because wages are part of provisional income, those earnings can work against their best interests as far as taxes are concerned if they began claiming Social Security in the same year.
There might not be much retirees can do right now to lower their tax liabilities this tax season, since 2021 is behind us, but they can begin preparing for the 2023 tax season. “Early planning is the key,” said Rose Swanger, a certified financial planner and principal of Advise Financial. Ideally, workers would start thinking about their income sources in retirement five to 10 years beforehand, so they can have a better understanding of what they’ll pay in Social Security taxes and medical premium surcharges, she said.
Retirees might also want to opt for a qualified charitable distribution, or QCD, if they’re financially comfortable to do so, Swanger said. With QCDs, retirees give their required minimum distributions to charities, which then excludes the withdrawal from taxable income.
Also see: Should I claim Social Security at 70, or take it earlier and invest the money?
Roth conversions are another option, and withdrawals from Roth 401(k) plans or IRAs are not considered part of provisional income calculations, Gessner said. Because individuals must pay taxes on the amount of money they are converting from a traditional account to a Roth account, workers and retirees alike should work with a qualified financial planner or tax preparer who can determine how much can be converted without pushing the person into a higher tax bracket. Those converted dollars will then continue to grow tax-free.
Some retirees might also want to ask the Social Security Administration to withhold a portion of their benefits, Johnson said.
The cost-of-living adjustment for Social Security was only 1.3% in 2021, so that likely would not have thrust benefits into taxable territory. But retirees should pay close attention to what income they receive in 2022, and how much they can reasonably expect to pay in taxes next year. The COLA for 2022 was 5.9% – “it is going to affect us next tax season,” Johnson said. “We need to plan carefully and we need to do that now.”
