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Reducing Taxes on Social Security Benefits

Throughout your working career, you paid taxes into the Social Security system. Then, when you retired, you started to receive benefits from the system.

You might think that because your benefits were at least in theory the result of your contributions, your Social Security benefits should be non-taxable. After all, if you pay taxes in but are then also taxed on the benefits, isn’t that double taxation?

For nearly the first fifty years of the existence of the Social Security program, the federal government agreed with you – Social Security benefits were treated as non-taxable income. But, of course, the government’s ever-increasing need for tax revenue caused it to change all that in 1984, when up to 50% of a retiree’s Social Security benefits became taxable, and again in 1994. Now, up to 85% of a retiree’s Social Security benefits are considered taxable income.

What you may not know is that annuities can potentially help you reduce or even eliminate taxation of your Social Security benefits.

Here’s how it works. As a taxpayer, on line 20a of your form 1040, you must fill in the amount of the Social Security benefits you receive. That’s fine, but on line 20b, you must calculate and fill in the amount of the benefits that are taxable. Ideally, regardless of the amount on line 20a, you would like line 20b to be zero.

As usual, the mechanics of tax calculations can seem bewildering. After all, how you get from line 20a to line 20b takes up a full page in the IRS form 1040 instructions document. Fortunately, the fundamentals are fairly easy to understand.

First, you add up the following figures:

  • HALF of your Social Security income, plus
  • ALL of your other income, such as:
  • Wages
  • Pensions
  • Taxable interest
  • Dividends
  • Capital gains
  • Business income
  • And even otherwise tax-exempt interest, such as interest on savings bonds and municipal bonds

For married taxpayers, if this sum exceeds $44,000, up to 85% of your Social Security income is taxed. If this sum is between $32,000 and $44,000, up to 50% of your Social Security income is taxed. For single taxpayers, the two threshold income numbers are lower: $34,000 for 85% and $25,000 for 50% taxable benefits.

Naturally, the last thing you want to do is decrease your income just to decrease your taxes. The golden question is, “How can you earn more than these amounts yet shelter your Social Security benefits from taxation?”

The answer is to recognize a factor that is missing in the combined income formula you see above: Deferred annuity interest that remains in the annuity and is not withdrawn is not included in the above calculation!

Let’s see how this fact can affect you. Let’s suppose that you are retired and your income comes primarily from Social Security and pension income. Let’s also suppose that you have savings somewhere other than in an annuity, and even though you are not withdrawing any money from your savings, the interest income on that savings is causing your Social Security benefits to be subject to income taxes.

If you move that savings into a deferred annuity, then any year that you don’t withdraw money from the annuity, the interest you earned in the annuity doesn’t count in the above calculation. That reduces or eliminates taxes on your Social Security benefits. Pretty sweet, isn’t it?

Here’s the icing on the cake: when you put your money into a fixed or fixed indexed annuity, your money could easily be safer and/or earning a higher rate of interest than where you have the money today, so you win in two ways!

This article is for general information purposes only. We do not provide investment or tax advice. If such advice is needed, the advice of a qualified advisor should be sought.

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