Avoid the Social Security Tax Torpedo

Heading into retirement, many people think they will be in a lower tax bracket. But then they realize once they receive their Social Security that they have a Social Security tax torpedo. This tax phenomenon is caused when an individual’s marginal tax rate is significantly higher than their actual tax bracket, which is a horrible experience.

You might be saying to yourself, “I never heard such a thing,” in your Katt Williams voice. What is it? Oftentimes we think when we receive Social Security benefits that the benefits we receive are income tax-free. But as a retiree's income increases, their Social Security benefits become taxable, which makes it a Social Security torpedo.

So, the more you make in IRA withdrawals, interest, dividends, or capital gains, the more your Social Security benefits are taxable. Bummer!!!

Imagine that for every $1 of your Social Security benefits, $.85 is taxable. This can definitely diminish the quality of life for many retirees. 

Here is a better example:

• A person in the 10% tax bracket has a true tax rate of 18.5%.
• A person in the 22% tax bracket has an effective tax rate of 40.7%.

How can we get around this, you are asking?

Take less money. But you are saying, “I need this money so I can live and keep my lifestyle up.”

Do Roth conversions before applying for Social Security. We can't avoid Uncle Sam, but we can take some action steps to lower or reduce how much we pay in taxes over our lifetime. The key to Roth conversions is doing it in years when we have low income tax rates. Pay the taxes then. We never have to worry about taxes coming out of the converted part again!!!

So, if we are in the 24% tax bracket, we want to convert as much as we can before we put ourselves in the 32% tax bracket. This is a steal if we are going to be in the marginal tax bracket of 40.7%. 

There are some additional perks as well:

• We reduce our IRA balance that might trigger Social Security taxation.
• The amount we convert is not calculated when forced to take the dreaded RMD (Required Minimum Distribution).

We have some tax-free retirement income.

When doing this strategy, don't do it alone. Make sure you discuss this with your tax and financial professional before doing it. You cannot reverse a Roth IRA conversion. So, we need to make sure this is the right move for you. Also, we don't want to convert too much at once, which puts you in a higher tax bracket — which defeats the purpose altogether.

If you're concerned about how taxes could impact your Social Security benefits — or simply want a second opinion on your retirement strategy — we're here to help. Click here to schedule your free consultation and let's create a plan that keeps more money in your pocket throughout retirement. Don't wait until it's too late to make a difference!