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How to avoid paying taxes on Social Security income

By James Royal

8/22/2021

Yes, it’s possible to avoid paying taxes on your Social Security, but it requires some careful maneuvering. While avoiding taxes on your monthly benefit check may sound like a good thing, retirees and other beneficiaries may want to think twice before trying to make it happen.

Here’s how the experts say you can avoid taxes on Social Security, why you might not want to, and what taxes you may end up paying on your monthly benefit check.

How much of your Social Security is taxable?

It’s possible – and perfectly legal – to avoid paying taxes on your Social Security check. In fact, only about 40 percent of recipients pay any federal tax on their benefit.

But here’s the caveat: To receive tax-free Social Security, your annual combined, or provisional, income must be under certain thresholds:

$25,000, if you’re filing as an individual
$32,000, if you’re married filing jointly

For married filing separately, the Social Security Administration simply says that “you’ll probably pay taxes on your benefits.”

Your combined income consists of three parts:

Your adjusted gross income, not including Social Security income
Tax-exempt interest
50 percent of your Social Security income

Add those amounts up and if you’re under the threshold for your filing status, you won’t be paying federal taxes on your benefit.

Even if you’re above this threshold, however, you may not have to pay tax on your full benefit. You may pay taxes on only 50 percent of your benefit or on up to 85 percent of it, depending on your combined income.

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For individual filers:
- Combined income between $25,000 and $34,000, up to 50 percent of your benefit is taxable
- Combined income above $34,000, up to 85 percent of your benefit is taxable
For married filing jointly:
- Combined income between $32,000 and $44,000, up to 50 percent of your benefit is taxable
- Combined income above $44,000, up to 85 percent of your benefit is taxable

At the end of each year the Social Security Administration will send you a benefit statement that shows what you received during the year. You can use that to figure out how much of your benefit is taxable and what you might need to do to minimize your taxable income in the year ahead. Here’s how your Social Security benefits are calculated.

How to minimize taxes on your Social Security

If your Social Security benefit is relatively fixed, albeit with small annual increases, you really have only two avenues left to get into that tax-free zone: reducing tax-exempt interest or adjusted gross income. And since most people don’t have tax-exempt interest, you’re left with one option.

“Therefore, the secret is to reduce your adjusted gross income in order to prevent provisional income from triggering a tax on Social Security,” says Kelly Crane, president and chief investment officer at Napa Valley Wealth Management in St. Helena, California.

Here are a few ways to reduce your adjusted gross income to get into the tax-free zone:

1. Move income-generating assets into an IRA

Most retirees are looking to pull money from their IRAs rather than put it in, but one way to reduce your income is to put income-generating assets into your IRA, where their interest or dividends won’t count immediately as income.

This strategy doesn’t mean you necessarily put new money into an IRA – which might not be possible if you’re not working – but rather move income-producing assets in taxable accounts into the tax-advantaged sheltering of an IRA. At the same time you may be able to shift assets such as growth stocks into taxable accounts, where gains won’t be taxable until the asset is sold.

For example, if you have a bond in a taxable account and a growth stock in an IRA, you could sell those and buy the bond in the IRA and the stock in the taxable account. You’ll reduce your taxable income without reducing your total income.

That said, if you make the switch, you’ll want to be sure you’re not incurring any unnecessary capital gains taxes in your taxable account, defeating the purpose of the switch.

2. Reduce business income

If you’re receiving partnership income or other business income, see if you can minimize it.

“Reduce any K-1 or pass-through income from a business by increasing business deductions or expenses,” says Crane.

This strategy might not be possible every year, but you could also consider bunching your deductions and expenses into alternating years, so that your Social Security income is taxable every other year.

3. Minimize withdrawals from your retirement plans

Money that you pull from your traditional IRA or traditional 401(k) will count as income in the year that you withdraw it. So if you can minimize those withdrawals or even not withdraw that money at all, it will help you get close to the tax-free threshold. Of course, this may not apply if you’re forced to take a required minimum distribution (RMD) that pushes you over the edge.

If you’re not forced to take an RMD in a given year, consider taking money from your Roth IRA or Roth 401(k) instead and avoid generating taxable income.

4. Donate your required minimum distribution

If you can’t wiggle out of taking your RMD from a traditional IRA, then donate it to charity to get into the tax-free zone. The donation could allow you to deduct the amount from your adjusted gross income. But you’ll have to be eligible for the qualified charitable distribution rule, including being over age 70 ½ and paying the distribution directly from the IRA to the charity.

That’s a strategy that Crane suggests, though he acknowledges that some people will have too much income and simply won’t be able to lower their adjusted gross income.

5. Make sure you’re taking your maximum capital loss

If you’ve invested in stocks or bonds and have a loss on paper, you might want to sell and realize that loss so you can claim it as a tax deduction. The process is called tax-loss harvesting, and it can net you a sizable deduction from your income.

The tax code allows you to write off up to a net $3,000 each year in investment losses. A write-off first reduces any other capital gains that you’ve incurred throughout the year. For example, if you have a $3,000 gain on one asset but a $6,000 loss on another, you can claim a deduction for the full $3,000 net loss.

Any net loss beyond that $3,000 has to be carried forward to future years, at which point it can be used. And even if you can’t realize the full value of that net loss, it can still make sense to realize some loss, especially if it pushes your Social Security benefit into the tax-free area.

Tax-loss harvesting works only in taxable accounts, not special tax-advantaged accounts such as an IRA.

Other things to watch out for

While everyone likes to minimize their taxes, especially ones that you can avoid without too much legwork, it’s important that you keep things in perspective.

“Tax strategy should be part of your overall financial planning,” says Crane. “Don’t let tax strategy be the tail that wags the dog.”

In other words, make the financial moves that maximize your after-tax income, but don’t make minimizing taxes your only goal. After all, those who earn no income also pay no taxes but earning no income is not a sensible financial path. For example, it can be better to find ways to maximize your Social Security benefits rather than minimizing your taxes.

And it could be financially smart to first avoid some of the biggest Social Security blunders.

Don’t forget that these rules apply to minimizing your tax at the federal level, but your state may tax your Social Security benefit. The laws differ by state, so it’s important to investigate how your state treats Social Security.

“There really aren’t any tricks, you just have to be careful with your interest and dividends,” says Paul Miller, CPA, of Miller & Company in the New York City area.

Bottom line

While the idea of tax-free Social Security is nice – and many people do avoid federal taxes on their benefit check – the cost of that is having an income that’s under a relatively low threshold.

If you can make some sensible changes to how you realize income, then aiming for tax-free Social Security could make sense. But for many others, it would require a massive overhaul of their lifestyle or is otherwise simply impossible given their income and assets.

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