When do clients in a 15% tax bracket pay 27.5% tax? When they must account for taxes on Social Security benefits. About 30 years ago, all Social Security benefits were tax-free. That's history, but there are still many ways planners can crack the tax code and save money for seniors and disabled clients.
Social Security recipients are taxed on what's known as combined income (it used to be called provisional income). It's the total of 50% of Social Security benefits, plus all of a taxpayer's other income - including tax-exempt interest. Once combined income is determined, taxpayers fall into one of three categories:
*TOO LOW. If a client's combined income is less than $25,000 (or $32,000 on a joint return), Social Security benefits won't be taxed. Such clients may not need tax planning.
* TOO HIGH. While up to 50% of benefits may be taxable for clients whose income exceeds the thresholds, up to 85% of Social Security benefits can be taxed for clients with combined incomes of more than $34,000 (or $44,000 on a joint return). Clients with much higher combined incomes may owe income taxes on 85% of their benefits regardless of tax planning strategies. "For quite a few clients, tax planning won't affect the tax on their Social Security benefits," says Jason Sandos, a registered investment representative with Capital Financial Services in South Jordan, Utah. "Some have so little income they don't need any planning, while others have so much income that they'll definitely owe the maximum tax on their benefits."
* JUST RIGHT. Some seniors have combined incomes that are neither too high, nor too low, and would likely benefit from tax planning. A married couple with $37,000 of outside income, along with $10,000 of tax-exempt interest income and $20,000 of Social Security benefits, would have a combined income of $57,000. The couple would be taxed on the maximum 85% of the benefits. While clients whose combined income is far greater would have a difficult time avoiding the maximum tax on Social Security benefits, those who fall within or just above the range may reap substantial tax savings from savvy financial planning.
If our hypothetical couple can drop their other taxable income to $34,000 from $37,000, the amount of their Social Security benefits subject to income tax will drop to $14,500 (72.5% of the benefit) from $17,000 (85% of their benefits). A $3,000 drop in other income effectively cuts a couple's taxable income by $5,500, counting untaxed Social Security benefits, and saves $825 in a 15% bracket.
Look at these numbers in reverse. If the couple has $34,000 in other taxable income, adding $3,000 in taxable investment or earned income would increase their tax bill by $825. This couple falls within a 15% tax bracket but would actually pay 27.5% in taxes on that $3,000 in additional income.
LOWERING TAX BILLS
How can tax advisors help clients keep their taxes down? Here are five strategies to pursue:
* Change investments. To lower a tax bill, some advisors suggest that clients alter their investment strategies. For some, that could be as easy as investing in an annuity, says Mary McGrath, executive vice president of Cozad Asset Management in Champaign, Ill. "They can avoid reporting the income until money is withdrawn," she says.
Sandos suggests that a retiree who doesn't need income immediately choose a deferred annuity, especially if the interest earned will push the client into having his or her Social Security benefits taxed. If a senior needs some cash flow, Sandos suggests a split annuity.
Some money would be placed in an immediate annuity with a 10-year payout. This would be lightly taxed, since most of the cash flow is a return of principal.
Other funds could go into a deferred annuity. "The deferred annuity portion offers tax-deferred growth, historically at an interest rate that's higher than average CD rates," Sandos says. "The original principal may be restored at the end of the guaranteed period, which allows the investor to start the process over again at prevailing interest rates."
McGrath suggests that some clients invest in ETFs to avoid mutual fund taxable distributions, which can increase income and result in federal benefits being taxed. Marty Abo, who runs Abo and Co. in Mount Laurel, N.J., a CPA and planning firm, says investing in growth stocks or Series EE bonds rather than investments can lower combined incomes.
* Gauge gains. "Seniors should be careful about recognizing capital gains," McGrath says. "The actual tax can be much greater than 15% if the capital gain causes Social Security to be taxed." Harvesting capital losses can help hold down taxable capital gains.
* Fund retirement accounts. Some tax-deductible contributions can keep combined income in check. For seniors who earn small amounts from self-employment, "This income may be sheltered by adopting and contributing to a Simple IRA," McGrath notes. Earned income up to $14,000 can be fully sheltered from taxes this year with a Simple IRA. Tax-deductible IRA or Keogh contributions should be considered, Abo says.
* Consider Roth IRA conversions. "If a client converts a traditional IRA to a Roth IRA, Social Security benefits will probably be taxed that year because the conversion increases taxable income," Abo says. Clients might want to make smaller conversions spread over a few years. "I've also seen taking a onetime tax hit turn out to be worthwhile," he says. Withdrawals from a traditional IRA or a 401(k) are counted as taxable income, but converting to a Roth IRA may avoid taxes on future distributions because Roth IRA withdrawals eventually are tax-free and will not be included in the Social Security taxation calculation.
* Delay Social Security. "I have clients delaying Social Security while converting to a Roth IRA," says Mark Lumia, who heads True Wealth Group in The Villages, Fla. This tactic will let their qualified money grow tax-free in a Roth IRA, and they may not have to take required minimum distributions at age 701/2.
Deferring Social Security, perhaps starting as late as 70, will increase benefits, but count just 50 cents on the dollar in the calculation of combined income. If clients convert traditional IRAs to Roth IRAs before they start Social Security, the conversion income won't increase their income in years when Social Security might be taxable.
By converting to a Roth, clients won't have to take required minimum distributions from a traditional IRA. Such distributions are included in the calculation of combined income, but qualified Roth IRA distributions don't count for this purpose. "Clients would have a higher income from Social Security, they could save taxes, and they wouldn't have to worry about possibly paying future taxes at high rates on their Roth IRA distributions," Lumia says.
Donald Jay Korn is a contributing writer for Financial Planning. His latest novel, In for a Pounding, is available on Kindle and Nook.