Social Security is one of the most heavily relied-upon benefits for seniors today. Many older Americans would not be able to pay their bills without those monthly checks.
Now because Social Security benefits are earned by paying taxes on wages, you'd think those benefits would be yours to collect tax-free in retirement. But that's not automatically the case. Social Security benefits can be subject to taxes, and it depends on your income picture.
Choosing the right home for your retirement savings, however, could be your ticket to avoiding taxes on your Social Security benefits and getting to keep more of that money for yourself.
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When taxes on Social Security benefits come into play
Social Security benefits are not always subject to taxes. Whether taxes on benefits apply depends on your provisional income.
Provisional income is calculated as the total of adjusted gross income (AGI), tax-exempt interest income, and 50% of your annual Social Security benefits. If you're single with a provisional income between $25,000 and $34,000, up to 50% of your Social Security benefits could be taxed. If you're married filing jointly with a provisional income between $32,000 and $44,000, the same 50% threat looms.
Once your provisional income climbs above $34,000 as a single tax-filer, you could face taxes on up to 85% of your Social Security benefits. And if your provisional income lands above $44,000 as a married couple filing jointly, up to 85% of your Social Security benefits could be subject to taxes as well.
If these thresholds seem very low, it's because they were established decades ago and have not been lifted to account for inflation. That's intentional, because part of the way Social Security gets funded is taxes on benefits. Payroll tax revenue is the program's primary income source, but taxes on benefits help, too.
Withdrawals from retirement savings could push you over the edge
Not everyone enters retirement with money in a retirement savings account. But if you do have savings, withdrawals from a traditional IRA or 401(k) count as taxable income. That means they're counted as part of your provisional income. And they could push you to the point where your Social Security benefits become taxable.
Furthermore, once required minimum distributions (RMDs) start, you'll be forced to take money out of a traditional IRA or 401(k) and pay taxes on it. That means you may end up with a higher provisional income even if you don't need those forced withdrawals.
A Roth IRA could spare you from having your benefits taxed
Withdrawals from a traditional IRA or 401(k) count toward provisional income. But withdrawals from a Roth IRA do not. That's why saving for retirement in a Roth IRA could be your ticket to avoiding taxes on your monthly Social Security checks.
With a Roth IRA, you contribute to your retirement savings on an after-tax basis. This is different from a traditional IRA or 401(k), where contributions are made on a pre-tax basis.
But in exchange, a Roth IRA gives you tax-free gains and tax-free withdrawals. And if you have a Roth IRA, you also won't be forced to take RMDs in retirement, which gives you more flexibility.
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A Roth IRA isn't right for everyone
While Roth IRAs offer plenty of benefits, and they could be your ticket to keeping more of your Social Security checks, they aren't necessarily the right retirement account for everyone.
For one thing, a Roth IRA makes sense if you expect to be in a higher tax bracket in retirement than you're in now. But if the opposite is true, and you're a high earner, a Roth IRA might cause you to pay more taxes than you'd otherwise have to on your savings.
Furthermore, Roth IRAs offer benefits from an estate planning standpoint. People who inherit Roth IRAs can take withdrawals tax-free. But if you don't have children and aren't concerned with estate planning, that's not a compelling reason to choose a Roth IRA.
Finally, if you intend to be very charitable in retirement, a Roth IRA may not fit your plans. With a traditional IRA, qualified charitable distributions (QCDs) let you donate money to charities directly and avoid being taxed on your money while satisfying RMDs. If you like the idea of donating your savings, it doesn't pay to choose a Roth IRA.
Bottom line
Seniors who are living on just Social Security generally do not have to worry about having their benefits taxed. But when you start to introduce other income sources, that's when taxes on benefits can start to become a threat.
Saving for retirement in a Roth IRA could help you avoid having your Social Security benefits taxed. But you shouldn't necessarily limit yourself to a Roth IRA if it doesn't otherwise suit your financial situation.
Even if you end up with retirement savings in a traditional IRA or 401(k) plan, there may be other steps you can take to avoid paying taxes on your Social Security. It pays to work with a financial advisor or tax professional to explore your options if your goal is to keep as much of your Social Security as possible.
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