The Less Obvious Reason You Might Pay Taxes on Social Security

There are millions of older Americans today who rely on Social Security. For some recipients, those monthly benefits constitute their only source of retirement income. But there are plenty of retirees who have other income sources to access.

The latter situation is, of course, more ideal. If you earn an average wage, Social Security will take the place of about 40% of it in retirement. That’s a pretty sizable pay cut, which is why it’s best to have savings to supplement those benefits.

Of course, some people are able to live modestly in retirement and get by on Social Security alone. And you might think you’ll be able to avoid taxes on your Social Security benefits if your plan is to live off of just those monthly checks in retirement. But you may end up paying taxes on your Social Security for a surprising reason.

Will RMDs leave you on the hook for Social Security taxes?

You may be able to manage your bills on Social Security alone, thereby leaving your savings untouched. But if you have a traditional retirement account like an IRA or 401(k), you’ll only be able to get away with leaving it untapped for so long.

Once you turn 73 (or 75, depending on your year of birth), you’ll be forced to start taking required minimum distributions, or RMDs. And those RMDs could drive your total income up to the point where taxes on Social Security come into play.

And if you’re thinking you’ll just blow off your RMDs in that case, you may want to come up with a different plan. The IRS will penalize you 25% of whatever RMD you don’t take. So by not taking your RMDs, you’re basically throwing away money.

How to avoid surprise taxes on your Social Security benefits

If you don’t like the idea of paying taxes on your Social Security benefits, you should know that keeping your total income pretty low could be your ticket to avoiding them. But if you have your savings in a traditional retirement plan, that may be out of your control.

However, if you convert your retirement savings to a Roth IRA before RMDs become mandatory, you can avoid those yearly withdrawals, thereby keeping your income lower.

Roth conversions aren’t something to just dive into, though. When you do a Roth conversion, it raises your taxable income. So if you want to avoid paying taxes on Social Security, you should ideally try to do your Roth conversions before starting benefits.

For many people, that’s a tough thing to pull off, though. You may need to wait until your income drops enough to make Roth conversions make sense from a tax perspective.

Let’s say you’re earning $150,000 a year at age 64, but then you retire and start Social Security at 65. If your annual income falls to $36,000 upon starting Social Security because you’re living on just those benefits, then that’s a good time to do Roth conversions. But then in that case, those Roth conversions might propel you into the category of having your Social Security benefits taxed.

All of this might sound like a giant Catch-22. But with proper planning, you may be able to avoid RMDs — and the impact they could have on Social Security.

If not, your next best bet is to simply plan to have your benefits taxed. Working with a financial advisor or tax professional is a smart move in that case, as they can help you develop strategies to mitigate that blow.