How to pay NO TAX on social security
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Yes, this is a real situation that most people should find themselves in if they start planning early enough. No, there is nothing illegal about this strategy with the current tax policy.
The fact of the matter is-- this strategy isn't that complicated and is an applicable strategy for the top 1%, as well as the bottom 99%. It's an all encompassing approach that ought to be applied.
LET'S UNDERSTAND THE TAX AVOIDANCE STRATEGY
If social security is your only source of TAXABLE income, then you will end up paying zero in taxes. This is how our current provisional tax code works out. More about this later in the article. If a retiree can keep their expenses low to stay comfortable with this level of income, that is a bonus.
Roth Retirement accounts aren't TAXABLE income. The reason for this is because Roth accounts are funded with money that has already been taxed. Therefore, it is free from double taxation. These Roth accounts ought to be thought of as savings accounts that sit at your bank next to your checking account. Obviously, withdrawals from those accounts aren't taxed simply because that cash has already been taxed once before. Due to these reasons-- Roth accounts can't interfere with social security income taxation. VERY IMPORTANT.
Traditional retirement accounts are taxed as ordinary income during retirement. Furthermore-- these traditional retirement accounts put your social security income at risk of taxation. The traditional retirement accounts are a roadblock if one is interested in retiring in a tax free situation.
If someone has traditional 401K or traditional IRA accounts, they can look into a Roth conversion. Please know that these conversion have present day tax implications. However, one can do small chunks of rollovers to limit the present day tax burden each year.
IT MAY MAKE SENSE TO SPEND YOUR ENTIRE TRADITIONAL RETIREMENT ACCOUNT BALANCE IF YOUR NEST EGG IS ON THE SMALLER SIDE AND YOUR BILLS ARE ON THE HIGH SIDE.
It sounds insane to suggest that an individual ought to spend all of their retirement account balance at 70 years old. But-- In some situations it makes all the sense in the world.
Dave and Sarah
62 years old
$800,000 in a Traditional Taxable IRA
$4,000 in monthly bills (mortgage, healthcare, and utilities).
Early retirement benefit taken at 62 years old is $4,400 combined.
Full retirement benefit of $6,400 combined
Benefit with three years of tax credits (70 years old) is $7,300 combined.
PLEASE UNDERSTAND: Social security credits build at 8% per year when someone foregoes accepting their distribution until a later age.
Once the benefit is accepted-- the Cost of Living Adjustment (COLA) raises the benefit each year by the Consumer Price Index (CPI). The CPI typically increases between 2-3% per year.
So it makes sense for Dave and Sarah to delay accepting their social security payments in order to build those credits. That way they increase their yearly benefit by 2-3% from a much larger yearly payment.
SCENARIO: Dave and Sarah withdraw $80,000 per year from their traditional IRA at age 62 and forego social security.
Standard deduction: $25,100
Provisional Income: $54,900
Tax bill with current tax code: $6,193
RETIREMENT STREAM OF $73,000 WHILE USING A WITHDRAWAL RATE OF 10%
At 70 years old most of the nest egg has been depleted.
TIME TO ACCEPT SOCIAL SECURITY AT 70 YEARS OLD
Dave and Sarah begin accepting $87,600 per year in social security as their only source of income. They will pay ZERO in taxes!
HOW IS SOCIAL SECURITY TAXED?
1. The first $32,000 per individual benefit of social security isn't taxed at all.
2. Only half of the individual benefit between $32,000-$44,000 is subject to tax.
-Therefore Dave and Sarah have $24,000 between the two of them open for taxation.
3. Married couples filing jointly will have a standard deduction of $25,100 to decrease their tax bill.
- So Dave and Sarah's amount open for taxation is completely wiped out by their standard deduction.
If Dave and Sarah use this social security strategy, they can have a yearly income of $87,600 tax free! Also, they won't have to worry about any market volatility.
RETIREES NEED TO LOOK AT SOCIAL SECURITY AS THE ULTIMATE BOND PAYMENT
Retirees with traditional retirement accounts ought to exhaust their accounts in order to escape the pressure of RMD's (Required Minimum Distributions). These are government enforced withdrawals placed upon individuals as they get older. My advice is to spend these accounts at a rate the retiree prefers before it is pressed upon someone. In the meantime, a retiree can wait patiently for their social security credits to build.
LOOK FOR THE ROTH--SOCIAL SECURITY COMBO
People ought to be funding their Roth accounts in order to keep their social security benefit completely tax free. The traditional retirement accounts combined with social security acts as a tax bomb pointed at your net worth.
John Lawrence is a financial advisor and founder/owner of J.A. Lawrence Wealth Management.
Reach out to John and J.A. Lawrence Wealth Management