The average monthly Social Security benefit for a retired worker was about $1,230 at the beginning of 2012. That's about $15,000 of income for the year. If you are receiving Social Security benefits, this means that you worked and paid taxes for at least 10 years. Wouldn't it be nice to avoid paying tax on your Social Security benefits while in retirement? By planning ahead, you can avoid paying tax on your Social Security income and your effective tax rate will be very low.
If Social Security is your only income, then you probably won't have to pay any taxes on it at all. Even if you have more income from your pension or IRA distribution, you still might not have to pay tax on your Social Security income. Here's a look at how your Social Security benefit is taxed:
First, you need to figure out your "combined income." This is your adjusted gross income plus non-taxable interest plus half of your Social Security benefit.
--If your combined income is under $25,000 for singles ($32,000 for couples filing jointly), then your benefits aren't taxable.
--If your combined income is between $25,000 and $34,000 for singles ($32,000 to $44,000 for couples), then you will have to pay income tax on up to 50 percent of your benefit.
--If your combined income is over $34,000 for singles ($44,000 for couples), then you will have to pay income tax on up to 85 percent of your benefit.
The good news is you won't ever have to pay income tax on 100 percent of your Social Security income. But there are still steps you can take to reduce taxes on your Social Security income.
If you want to minimize tax, then you should try to keep your combined income at around $25,000. For example, let's assume you received the average Social Security benefit of $15,000 in 2012. If you withdraw $17,500 from your IRA, your combined income will be right at $25,000. Your real income would be $32,500. That's $17,500 from the IRA and $15,000 from Social Security. (In this example your combined income is $17,500 plus half of $15,000 which equals $25,000.)
If you take the standard deduction ($5,950) and standard exemption ($3,800), then you'll only have to pay $778 in tax on an income of $32,000. That's a 2 percent effective tax rate.
Diversify your retirement income. It's nice to pay only 2 percent tax, but what if $32,500 isn't enough to live on? This is why you need to diversify your retirement income. For example, you can withdraw $5,000 from a Roth IRA and it won't change any of the calculations above. You can also withdraw from your savings accounts or CDs, and you won't have to pay tax on this income either.
Minimize expenses. The easiest way to minimize combined income is to keep your expenses low after retirement. This is a major reason it's a good idea to pay off your mortgage before you retire. A mortgage payment is the biggest monthly expense for many households. If you can eliminate that bill, then it will be much easier to live on $32,500 per year.
Around this time of the year, no one likes the word "tax". The tax code is incredibly complicated, and it's a huge headache to deal with. However, if you plan it right, you won't have to pay much tax at all in retirement. It is a great feeling to be able to keep more of your money when you need it the most.
Joe Udo blogs at Retire By 40 where he writes about passive income, frugal living, retirement investing, and the challenges of early retirement. He recently left his corporate job to be a stay at home dad and blogger and is having the time of his life.