How to Avoid the Social Security Tax Torpedo

Knowing how to avoid the tax torpedo means you can pay less taxes during your retirement years. Vitalii Vodolazskyi/Shutterstock

When you start receiving Social Security benefits, you may discover that they put you into a higher tax bracket if you’re still earning an income. You may also find that your benefits will be reduced because of those earnings.

Adding Social Security benefits to the earnings you get from a job and any required minimum distribution (RMD) from retirement plans could significantly impact your taxes, as well as your Social Security income if you are under your full retirement age.

The sudden increase in your taxes can be shocking—hitting you like a tax torpedo.

Instead of being caught completely off-guard by the tax torpedo and the temporary loss of an expected portion of your benefits, you can avoid it. If you are getting close to retirement, the sooner you act, the better.

Although the Social Security Administration (SSA) has set some limits on how much you can earn from a job without losing any of your Social Security benefits, you can still get benefits and work simultaneously. It is just that some, or in some cases all, of your benefits will be withheld once your earned income exceeds the limit set by the SSA, depending on how much you earn above the limit.

Any money withheld from your social security payments will be paid back with your regular benefits after you reach full retirement age, giving you a larger monthly check.

Earnings Limit for Singles

For singles, Social Security benefits start being withheld at $1 for every $2 earned over $22,320. It is equal to 50 percent of your earnings above the limit. You may not receive any benefits for some time if you earn much more than the limit.

In the year you will reach full retirement age, a single person can earn up to $59,520 in the months before their birthday month. Your benefits are withheld at $1 for every $3 earned during those months. After your birthday month, when you reach full retirement age, no benefits will be withheld no matter how much you earn.

Reducing Your Future Taxes Before You Retire

One of the best ways to reduce your taxes from retirement accounts (traditional IRAs and 401(k)s) is to roll your money into a Roth account. Roth accounts, either a Roth IRA or a Roth 401(k), allow you to make withdrawals at your leisure after you are 59 1/2 because they do not have any RMDs.

All withdrawals from a Roth account are nontaxable if the money has been in it for at least five years. You will have to pay taxes on the funds rolled over, but once they are in the account, all growth is tax-free. Leave it in for your heirs if you want to.

Avoid rolling all your money into a Roth account in the same year. You can save money on taxes by making rollovers over several years instead of paying a large tax bill in a single year.

Taking advantage of the rollover reduces your taxes significantly because you can earn thousands of dollars of interest without taxes. Since you also control any distributions, you can withdraw money when needed without worrying about taxes on them. ThinkAdvisor says Roth accounts can help you reduce the tax torpedo even if you have a couple of million dollars in your account.

Contribution Limits to Roth Accounts

The same limits apply to traditional and Roth accounts if you contribute to a Roth IRA. In 2024, the limit is $7,000. If you are 50 or older, you can contribute an additional $1,000 per year.

A Roth 401(k) has much higher contribution limits, allowing you to add up to $23,000 in 2024. If you are 50 or older, you can contribute an additional $7,500 each year.

Withdraw Money From Retirement Accounts Early

If you do not rollover your retirement money (or all of it) into a Roth account, remember that you can withdraw from retirement accounts after you are 59 1/2 years old. Doing so reduces the interest you will receive and the size of your RMDs when you must make them, which means you pay less taxes on each one. Taking RMDs before you claim Social Security will not affect your benefits.

Larger RMDs from non-Roth accounts could quickly put you into a higher tax bracket, causing you to pay even more taxes—and reducing your Social Security benefits even more. It could also impact your Medicare cost, requiring you to pay much more—and not get any more medical benefits.

Wait to Take Social Security Benefits

Using money from RMDs or withdrawing from a Roth account to live on could enable you to wait until you reach full retirement age, or until you’re 70 (the age at which you can receive 124 percent of your full monthly benefit), to get Social Security benefits. Waiting will allow you to get the maximum benefits. You could also supplement your income from brokerage accounts, a reverse mortgage, savings, or the cash value from a whole life insurance policy.

Pay Taxes in Advance

The SSA will let people pay the withholding amount on their benefits in advance. You can ask the IRS to withhold 7 percent, 10 percent, 12 percent, or 22 percent of your monthly payment.

Having a Roth account is a critical factor in avoiding the tax torpedo. Many employers offer it, but not all of them. Consult a financial adviser or estate planner to discover even more ways to reduce your taxes during retirement.

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