Personal Finance

Beware of This "Tax Torpedo" That Comes Along with Social Security

David Beren

Published: November 4, 2024 12:30 pm

Last Updated: November 4, 2024 3:51 pm

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• The Social Security “Tax Torpedo” can be a huge surprise for many people.
• The good news is that you can find loopholes around this surprise. 
• Millions rely on social security to enjoy a better life during retirement.
• Also: Are You On Track to Retire? Take This Quiz and Find Out ^(Sponsored) 

While relying on social security to live well during retirement is not unheard of, it’s also not problem-free. Unfortunately, taxes don’t end once you retire, which means that even after you leave the workforce, you still have to pay Uncle Sam. 

Enter the Social Security “Tax Torpedo.” This nickname for an increase in income from social security payments is often a major surprise to those who didn’t plan for this bump into another tax bracket. As a result, the amount of money you expect to have as a retiree becomes, in some cases, significantly less. 

What Is The Social Security “Tax Torpedo?”

Before discussing how to avoid the Social Security Tax Torpedo, it’s essential to understand what it is. As hinted at earlier, this type of tax spikes the amount of tax deductions retirees could face while receiving their Social Security Benefits. 

While some requirements exist, like age and income level, the Social Security Administration will likely start issuing payments for people around 66 or 67. This is when most people are likely to consider retirement and request to begin receiving Social Security Benefits. 

In more simplistic terms, if you are still drawing income from other sources in retirement, adding Social Security to your total earnings could increase your marginal tax bracket. This would mean that your overall income level jumps into the next tier of tax deductions, which means your payments to the government are higher than you anticipated. 

How to Avoid the Social Security “Tax Torpedo” 

If you want to avoid the tax torpedo, you can do so, but it will require some planning, which must be done beforehand. It’s important to note that I am not a tax professional and don’t play one on television. In other words, please consult a CPA or tax professional for specialized advice on your unique situation. 

Live In a Tax-Free State

Among the easiest ways to avoid the dangers of the tax torpedo is to live in a tax-free state. Out of the 50 states, only 10 states in 2024 will tax your Social Security check, so if you live in any of the other 40 states, you can save on taxes. This means that you want to avoid residency in these states: Colorado, Connecticut, Kansas, Minnesota, Montana, Nebraska, New Mexico, Rhode Island, Utah, and Vermont. So long as you live in a state other than these, you shouldn’t worry much about the federal tax torpedo. 

Roth IRA

One of the biggest advantages of using a Roth IRA is that you contribute to this account using after-tax dollars. This means you don’t see a tax deduction when you contribute, meaning distributions made during your retirement years are tax-free. 

Any income derived from a Roth IRA set up pre-retirement also doesn’t count toward your taxable income. So, by relying heavily on this type of retirement account for income, you are avoiding the eventuality that 50-85% of your Social Security benefit will be taxed. 

Delay Social Security

Many people are taking a big step to avoid the tax torpedo: delaying their Social Security payments. While this isn’t a permanent solution, if you avoid receiving any payments until you turn 70 by relying on other means of income, you’ll find yourself with a couple of advantages. 

The first advantage is that you can increase your payment amount. Separately, you’ll avoid having to make any payments on Social Security taxes if you aren’t drawing any money from the fund. If you can live on an IRA for a while, you will have more control over your income and how much you are paying in taxes. 

Donating IRA Income to Charity

Those using Qualified Charitable Distributions (QCDs) can donate directly from a traditional IRA to a charity. As of 2024, the government doesn’t consider donations up to $100,000 in taxable income. 

To be clear, this won’t directly impact your Social Security tax, but it does offer one distinct benefit. Using a QCD allows you to lower your taxable income, reducing the portion of your Social Security benefits that would otherwise be subjected to taxation yearly. 

Some specific caveats with this avoidance method are that it has to be a donation made directly from a traditional IRA and that you must have enough disposable income or available money to make this approach successful, which isn’t the case for everyone. 

Qualified Longevity Annuity Contract

Another potential method for avoiding the Social Security tax torpedo is to purchase a Qualified Longevity Annuity Contract. This type of annuity is a specialized purchase that will provide buyers with guaranteed income later in life or during retirement. 

This annuity contract allows you to transfer up to $130,000 from your traditional IRA or 401K to the QLAC. Once you make this transfer, you have sidestepped the required minimum distribution you need to take from a retirement account. 

This means that the distributions you have taken from your 401 (k) or IRA won’t impact your annual income, which helps you mitigate the potential for increased Social Security taxes. 

Conversely, a QLAC has a delayed required minimum distribution compared to more traditional retirement accounts. This would allow you to delay making any distributions until you are 85, 12 years more than the age required by the government for making distributions from a 401K or IRA. 

Closing Thoughts

It’s important to remember that not everyone will suffer from the dreaded Social Security “Tax Torpedo.” This is especially true for those with lower incomes during their retirement years, who may not have to pay any taxes on their benefits. 

However, without carefully planning for the future, you could be subjected to taxation that hits 85% of your Social Security income, which could be a big “ouch” for those heavily reliant on this money to live and survive. 

Ultimately, the best thing you can do is contact a tax professional if you think you will be subjected to this torpedo and work with them to prepare ahead of time to mitigate the amount of money you will lose.