Why should you pay taxes on your social security? Stop now!

Social Security has been around since 1935. The idea was a good one at the time. After all, our country was coming out of the Great Depression, and Social Security was intended to fill an obvious void. Fast forward 90 years, or at least close to 90 years, and this federal program still provides benefits to retirees and disabled individuals, as well as their dependents and survivors, funded by taxes. You will likely pay taxes on nearly every dollar you collect from Social Security, but under the hood we find a high-mileage engine that really needs to be overhauled.

What's next for Social Security? What can you do to eliminate paying tax on something you've already paid for in the form of taxes? I'm going to answer those questions and more. Stay tuned.

Welcome to We're Talking Money. I'm Phil Clark. Social Security is not as simple as it sounds, but it is the only legalized Ponzi scheme in the U.S. That's right, I said Ponzi. Just think about it. Taxes are taken today from every employee, and those taxes are used to pay benefits to current recipients of Social Security. If the taxes cease to exist, or if there's not enough of them, Social Security is gone.

Now, the repercussions of this model is significant. In fact, Social Security in its current form will be insolvent by 2035, and that's not coming from my assessment. That's coming from all the experts who are constantly looking at the program, and they've told us it will be insolvent by 2035 unless something is done. Rather than focus on what ultimately became a poorly run system, let's get more familiar with how it works and illuminate some blind spots.

Now, Social Security payments are funded through payroll taxes. The amount of Social Security tax an employee pays, it's based on their wages or salary, and the maximum taxable earnings for 2023 is a hundred sixty thousand two hundred dollars. So once your income reaches that amount, at least you're not paying more for Social Security. Now, why is there a limit? Well, because your Social Security is limited, so it stands to reason that the amount of salary that is taxed would also have a limit.

Employers also pay half of the total. In other words, Social Security tax is 6.2 percent, and you, the employee, pay the other 6.2 percent. Employer pay 6.2, you pay 6.2. Now, self-employed people, you're paying both halves, so you're paying 12.4.

To receive Social Security, benefits are not available to everyone. To receive it, you must be eligible and you have to meet the age requirements. Now, to get full retirement benefits, individuals born between 1943 and 1954 must be at least 66 years old, and for those born in 1960 or later, your full retirement age, or FRA, is 67. For individuals who need income before they reach their FRA, or full retirement age, there are reduced benefits available, and they start as early as 62. However, you can expect a pretty sizable reduction in benefits, maybe as much as 25 to 30 percent compared to full retirement age. Now, this is a blind spot, since most people are not sure how to calculate the ideal age at which they should take Social Security benefits.

Next, and unfortunately, Social Security benefits are taxable income. Doesn't make sense, because you have to use part of your income during your working years to pay for the benefit of Social Security. In fact, the IRS says that about 40 percent of those receiving Social Security will owe tax on their benefits. It just doesn't seem right. Is there a way to mitigate that risk, or to reduce that potential tax?

So whether or not you have to pay taxes on your Social Security depends on the total income, but not just earned income. So it depends on your income after you elect Social Security, whether that's at 62 or normal retirement age or anything in between. Fortunately, determining how much of your Social Security is taxed, it only takes a simple calculation. But as with most things, the devil is always in the details. That is, what income must be included?

Well, it may not seem logical, but basically it's any income: wages, self-employment income, dividends on your stocks, and other taxable income that has to be reported on your tax return. Oh, and don't forget, this will sound completely unorthodox, but tax-free municipal bond income, that's also included. That doesn't make any sense, so I know that it sounds like an oxymoron, but that's the government for you. I don't make the rules, I just let you know what they are.

Now, you take your income, all of these income sources, plus the non-taxable interest, that's the municipal bonds that I mentioned, and then one half of your Social Security benefit. This creates something called your provisional income, or combined income.

Now, if you file a federal tax return as an individual and your combined or provisional income is between twenty five thousand and thirty four thousand dollars, you may have to pay income tax on up to 50 percent of your benefits. If your earnings exceed thirty four thousand dollars, again as an individual, you might have to pay up to 85 percent of your Social Security tax, or rather, you might have to pay income tax on up to 85 percent of your benefit.

If you're married and file a joint tax return, and you and your spouse have a combined income that is between thirty two thousand and forty four thousand dollars, you may have to pay income tax on your Social Security of approximately 50 percent of the benefit. If your combined income is more than forty four thousand dollars, unfortunately, up to 85 percent of your Social Security benefit will be taxable.

Now, the thresholds are not very high, as we just talked about. Anyone who has saved well and planned and invested over many years, they're not going to have a problem exceeding those combined income limits. Fortunately, I'm here to share with you there happens to be some steps you can take to reduce, maybe eliminate, some of these taxes that you're going to likely owe on your Social Security benefits. Let's talk about those and figure out if they make sense for you.

The first: maximize contributions to a Roth IRA or a Roth 401k. You've heard people talking about Roth IRAs and 401ks for a number of years now. They are very popular tools, they are very powerful tools, but most people don't think about them in the context of planning for Social Security distributions or income. So this means you'll be making after-tax contributions to these types of accounts, but the earnings and distributions will never be taxed again. Herein lies the power. Best of all, Roth distributions, they are not considered when calculating that provisional or combined income.

Number two: if you are closer to retirement, consider a Roth conversion. Now, number one is for those people who still have time to contribute as part of their long-range plan, but if you're close to retirement, our second strategy is consider a Roth conversion. Now, this means converting existing retirement accounts to a Roth. Everyone can do this, but keep in mind this is a taxable event. That's the negative part of this. But again, future taxes are eliminated, Social Security tax will decrease in this case, and there's never a required minimum distribution once you move money to a Roth. Before you elect this strategy, please be sure it fits your situation. Your tax or financial advisor can help you make that determination, or you can talk to one of our advisors for help, but please be sure this one fits.

Now, number three: gross income is maybe not the same as adjusted gross income, and adjusted gross income is what we're talking about here. So when you're calculating your provisional income, be sure you are reducing that gross income to the extent possible to reach the lowest AGI, or adjusted gross income. This means to make sure that you're taking every allowable deduction. It also means be sure that you're working with a competent CPA that understands Social Security.

Number four: this may not be an option, certainly not for everyone, but if you're thinking about relocating for your retirement, try to land in a state with no income tax. Additionally, there are 38 states that do not tax Social Security. So whether they have an income tax is beside the point; there's at least 38 states that don't tax Social Security. I'll put a list of those states in the comments just below, so all you have to do is take a peek there and you'll know if those states happen to be one where you reside, or one that you're considering making your residence.

Number five: you could purchase rental property. Now, this one again is not for everyone, but if it's done properly, rental property can generate a lot of cash flow without adding income to your tax return. Now, that might sound too good to be true, but it's not. If you're not sure that rental property fits you, or if you're not sure how it works, let us know. Talk to one of our advisors, we'll help you, or talk to your tax preparer. Let them know what you're thinking and see if they believe it's a good fit for you.

Number six: tax loss harvesting. Now, if you listen to our shows regularly, you've heard us talk about this one, and this is not just about lowering tax on Social Security. This is a great strategy, period. Tax loss harvesting is another great tool, however, for reducing taxable income. So for example, if you're selling some stock for a gain, and that would otherwise be taxed as capital gains, you could look for other stocks in your portfolio that haven't done as well, and so perhaps they have some losses. If we take those losses, that technique allows you to use the loss to offset the capital gains, thereby decreasing your capital gain taxable income. That reduces the AGI, and that also means that you're going to pay less tax on your Social Security.

Now, when it comes to Social Security taxation, there is no panacea. There's no one-size-fits-all; those solutions don't exist. But everyone's situation, because it's different, chances are there is a solution of some sort that could be used. The most important thing is to make sure you understand how much of your benefit will be taxable so that you can plan accordingly, and after all, everything is about good planning. Doing so is going to help you maximize your retirement income and reduce any unpleasant surprises when it's time to file.

I hope this edition of We're Talking Money provided you with some useful information and inspiration to take a closer look at your Social Security situation. If you enjoyed the content, please like, share, and consider subscribing to our channel. We really appreciate your support. And don't forget, ring that bell so you never miss another one of these great episodes. I wish you a blessed day. I'll see you next time on We're Talking Money.

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