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Avoid Multiple Taxation on your Social Security Benefits

Depending on how you look at it, the retirement benefits you receive from Social Security may be taxed two or three times in the course of getting to your pocket or bank account.

As you well know, when you're working, you pay Federal and State taxes. That's the first level of taxation.

The second level of taxation occurs when you contribute to Social Security and Medicare through your FICA contributions. FICA stands for the Federal Insurance Contributions Act and is deducted from each paycheck. 6.2% goes to Social Security tax, and 1.45% goes to Medicare, for a total of 7.65%. FICA payments are made with after-tax income.

By comparison, IRAs, 401(k)s and 403(b)s are not subject to double taxation because when you make contributions, your taxable income is reduced by the amount of the contribution. You only get taxed when you take distributions in retirement.

Unlike your personal retirement accounts, the money you pay to FICA is not held in a personal account for you to use when you receive Social Security benefits. The FICA contributions made by today's workers pay for the benefits paid to current retirees. Some argue that this is like a Ponzi scheme, in which benefits are promised, but there is really no guarantee that those who are paying into FICA today will get their money back in the future.

Trump's 2020 budget proposal makes this even more unlikely. When he campaigned for president in 2015, Trump promised the Daily Signal, a conservative publication affiliated with the Heritage Foundation, that he would leave Medicaid (Medi-Cal in California), Social Security and Medicare untouched. However, over the next 10 years, his budget will cut $25 billion from Social Security and $1.5 trillion from Medicaid.¹ This includes a $10 billion cut to Social Security Disability Insurance (SSDI), a program that assists the disabled.

The trustees of Social Security and Medicare project that Social Security will deplete its $2.9 trillion reserve fund by 2035.² Those who are receiving Social Security benefits today may be secure, but the continuation of Social Security to their children may be in doubt.

After income tax and FICA tax, you could be taxed a third time on the same money when you receive Social Security benefits. Taxation on Social Security income is based on a formula called "combined income." Start with all your income, including tax-exempt interest (such as from municipal bonds), and add in half of your Social Security benefits for the year. If you're single, and your "combined income" is above $25,000 but below $34,000, you will pay federal taxes on 50% of your Social Security income. Above $34,000, 85% of your Social Security benefit will be taxed.

If you file jointly, and your "combined income" is above $32,000 but below $44,000, you'll pay federal taxes on 50% of your Social Security income. Above $44,000, you can expect to pay taxes on 85% on your Social Security benefits.

It's even worse if you live in Minnesota, North Dakota, Vermont, or West Virginia, where the states follow the same rules as the federal government. There, you could pay state taxes as well as federal taxes on as much as 85% of your Social Security benefit.

The first two levels of taxation are unavoidable unless you live completely off the grid. However, there are legal strategies available to duck the third level. One way to keep your taxable income low, and perhaps avoid taxation on Social Security benefits, is to shift more money into tax-free vehicles like the Roth IRA. You must fund a Roth IRA with after-tax money, but then it not only grows tax-free, but the distributions can be tax-free as well.

If you have earned income, you can make annual contributions to a Roth IRA of as much as $6,000 per year ($7,000 per year if you're over 50). However, if you're single and you make more than $122,000 per year, or a married couple earning more than $193,000 per year, your eligibility for making an annual Roth contribution phases out.

Fortunately, there is a work-around. If you have money in a Traditional IRA, you can do conversions to a Roth IRA without income limits. Whatever amount you convert is taxed at ordinary income rates, just like you earned extra income in that year. Therefore, you should work with your CPA, and convert a little each year without pushing yourself into a higher tax bracket.

If you think your taxes are going to be higher in the future, it might be a good approach to do Roth conversions. You will pay a little more tax now, but have more tax-free income down the road. Consult with your CPA or Certified Financial Planner™ to see if it makes sense for you.

¹ Vox.com 3/12/2019

² Barron's 4/22/2019

This commentary on this website reflects the personal opinions, viewpoints and analyses of the Kondo Wealth Advisors, Inc.  employees providing such comments, and should not be regarded as a description of advisory services provided by Kondo Wealth Advisors, Inc.  or performance returns of any Kondo Wealth Advisors, Inc.  Investments client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Kondo Wealth Advisors, Inc. manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.

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