As retirement approaches, your job is not to gift the IRS but to give what is owed—and not a penny more. In retirement, a sound understanding of the tax code will help you find the best strategy to keep taxes low and optimize income.

Let's explore Social Security tax issues and consider several ways to keep taxes as low as possible, while exploring various retirement income scenarios. (For more, see: Build a Retirement Portfolio for a Different World.)

Understand the Tax Issues

Social Security is typically the largest portion of your retirement income. To keep the most of this important annuity, you should understand how the proceeds may be taxed. As with most government programs, the Social Security tax calculations are complex. This overview will give you a basic understanding of what types of income is taxed and at what levels.

Eighty five percent is the maximum taxable portion of Social Security benefits. Regardless of your income level, 15% of your Social Security benefits are tax-free. The taxable amount of your Social Security benefit is determined by your total income. IRS.gov Publication 915 spells out the details with worksheets to complete the calculation.

Social Security Tax Calculation Tutorial

Use this equation to start:

Adjusted gross income from IRS Form 1040 (This includes wages, self-employment income, dividends, interest, capital gains, pension payments, rental income, and retired minimum distributions, etc.) (For more, see: How Is Social Security Tax Calculated?)

+ Nontaxable interest

+ ½ of Social Security benefits

= Combined Income

Once you have your income, then you can determine if and how much of that income is taxable. For example, Ricardo is single with a combined income between $25,000 and $34,000. Up to 50% of his Social Security benefits are taxable.

Olivia and Robert are married and filing jointly. If their combined income falls between $32,000 and $44,000, they may also be taxed on a maximum of 50% of their Social Security benefits. If their income is greater than $44,000, up to 85% of their Social Security benefits are taxable.

Regardless of whether your Social Security benefits are taxable or not, you may want to consider delaying them until age 70, when the benefits reach the highest level. (For related reading, see: Social Security 'Start, Stop, Start' Strategy Explained.)

Best Retirement Tax Strategies

Take a look at these guidelines for minimizing taxes in retirement:

Consider spending down IRA funds before taking Social Security benefits

If you’ve built up one or more IRAs during your working years, then you may want to consider this strategy. Waiting longer to claim Social Security benefits yields an increase each year that you wait after the full retirement age.

Delayed Retirement Credit

Birth Year

Credit per Year

1925-26

3.5%

1927-28

4.0%

1929-30

4.5%

1931-32

5.0%

1933-34

5.5%

1935-36

6.0%

1937-38

6.5%

1939-40

7.0%

1941-42

7.5%

1943 and later

8.0%

Source: http://www.ssa.gov/oact/quickcalc/early_late.html

If you live a long life you may receive greater lifetime benefits by waiting to claim until the maximum Social Security payment tops out at age 70. Also, with lower IRA balances at age 70.5, when the required minimum distribution (RMD) kicks in, you’ll be required to withdraw a smaller amount from your IRA. This may decrease or eliminate potential taxes on the Social Security benefits. Another advantage of taking the IRA withdrawals before Social Security is that it may yield greater total spendable retirement income.

The choice to delay Social Security is only beneficial if you live long enough to recoup the funds sacrificed by waiting to start your benefits until age 70. Also, if you spend down a Roth IRA, which has no RMD, you’ll forgo the possibility of passing this asset on to your heirs. (For more, see: Can my Child Have an IRA/Roth IRA?)

Convert traditional IRAs into Roth IRAs

There are several advantages to this strategy. Since Roth IRAs have already been taxed, their withdrawal doesn’t add to your combined income and won’t count toward Social Security tax calculations if you do choose to use the Roth IRA funds in retirement.

Additionally, there are no RMDs for Roth IRAs. In fact, your heirs can enjoy your Roth IRA, allowing it to grow and compound for many years.

The biggest drawback to this approach is that when you convert a traditional IRA to a Roth IRA, you need to pay tax on the untaxed funds. This immediate tax hit may surpass the potential long-term tax benefit of having the Roth IRA account.

Use Roth IRA funds in high tax years

If you are having a relatively high income year, you may wish to tap a Roth IRA for additional funds. Since you’ve already paid tax on the Roth IRA contributions, withdrawals are tax-free. This money can reduce potential taxes on Social Security benefits and also minimize the withdrawal amount needed from the traditional IRA.

Of course, traditional IRA withdrawals can only be minimized once the RMD limit is met. A simple underestimate of the RMD from a traditional retirement account costs you a 50% penalty, on top of the taxes owed.

The Bottom Line

When it comes to taxes, Social Security distributions, and retirement planning, you may save some money by meeting with a qualified financial advisor. The decisions around these retirement aspects can have long term financial effects. A financial advisor and/or a tax professional, abreast of the laws, can save you money and help you minimize taxes and maximize income in retirement. (For more, see: Are You Getting the Best Retirement Advice?)

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