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Avoid Social Security ‘Tax Torpedo’ with a Few Simple Strategies

Understanding Social Security

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One crucial aspect of Social Security retirement benefits is that you don’t have to stop earning income to collect them. This flexibility allows individuals to continue working while receiving Social Security benefits.

‘Tax Torpedo’ risks

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Despite the flexibility, there are risks involved, primarily the possibility of encountering a “tax torpedo” that could impact your overall income. It’s essential to be aware of potential tax implications associated with Social Security benefits.

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Retirement age and earnings limit

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The Social Security Administration considers you “retired” when you start receiving retirement benefits. If you are younger than full retirement age and earn more than the SSA’s yearly earnings limit, your benefits might be reduced. Understanding the correlation between retirement age, earnings, and benefit reduction is crucial.

2024 earnings test limits

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For the year 2024, you can earn up to $22,320 without any withheld benefits. It’s essential to stay informed about the specific earnings limits to optimize your Social Security benefits.

Earnings test limit mechanics

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If you are under full retirement age for the entire year, the SSA deducts $1 from your benefit payment for every $2 you earn above the annual limit. Familiarizing yourself with the mechanics of the earnings test helps you navigate potential reductions in benefits based on your income.

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Provisional income and taxation

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As for how Social Security benefits are taxed, it depends on your provisional income, which Fidelity refers to as “essentially your modified adjusted gross income, plus nontaxable interest income, and half of your Social Security benefits for the year.” Understanding the components of provisional income is crucial for tax planning.

Taxation thresholds

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Provisional income above $34,000 for a single filer and $44,000 for a married couple filing jointly can result in up to 85% of your Social Security benefit being taxed. Being aware of taxation thresholds helps you strategize and minimize potential tax burdens.

The tax torpedo

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The tax torpedo occurs when your provisional income moves you into a higher Social Security tax bracket. Recognizing the onset of the tax torpedo is vital for implementing proactive measures.

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Ways to avoid the tax torpedo

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Several strategies can help you avoid the tax torpedo. These include utilizing a Roth IRA, waiting until age 70 to claim Social Security, and exploring other financial planning options to optimize your retirement income.

Use a Roth IRA

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One effective strategy is to use a Roth IRA. Since distributions during retirement are tax-free, your Roth IRA income doesn’t count toward your retirement income. This approach provides a tax-efficient source of income in retirement.

Wait until age 70 to claim Social Security

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Delaying your Social Security claim until age 70 ensures you won’t have to pay any taxes on Social Security income. This strategic move allows you to maximize your benefit while minimizing tax liabilities.

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Other strategies

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Additional strategies to consider include relocating to another state, donating IRA income to charity, purchasing a Qualified Longevity Annuity Contract (QLAC), or seeking guidance from a financial advisor to optimize your Social Security benefits and overall retirement earnings. Exploring a range of strategies ensures a well-rounded approach to managing your financial future.

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