Allison Michael Orenstein | fake images
Social Security recipients are just beginning to see the record 8.7% cost-of-living adjustment on their monthly checks.
But come tax time, they could see surprises as a result of last year’s 5.9% increase, which at the time was the largest COLA in four decades.
Last year’s 5.9% cost-of-living adjustment was like receiving a 6% pay raise in 2022, according to Mary Johnson, a Social Security and Medicare policy analyst at The Senior Citizens League. That boost to benefits, however, wasn’t enough to keep up with rising costs, according to recent research from the nonpartisan seniors group.
A recent survey by The Senior Citizens League found that 57% of senior taxpayers fear more of their Social Security benefits will be taxed due to last year’s 5.9% cost-of-living adjustment. The survey, which was conducted last summer, included about 1,500 participants.
“There are a lot of people who are concerned,” Johnson said.
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The new 8.7% cost-of-living adjustment that went into effect this month may also complicate tax planning for the more than 65 million beneficiaries who rely on Social Security checks.
From a tax-saving perspective, there’s not much you can do to mitigate your liability this tax season, according to Brian Vosberg, a certified financial planner and registered agent who is president of Vosberg Wealth in Glendora, California.
“Once it’s December 31, there’s very little you can do to minimize your tax liability,” Vosberg said.
An exception is if you make a prior-year contribution to an individual retirement account before April 15, which can help reduce your taxable income.
However, it would be prudent for recipients to accelerate their tax planning for the coming year to mitigate the effects of the 8.7% cost of living adjustment.
How Social Security benefits are taxed
Social Security benefits are taxed based on a formula called combined income.
“The maximum Social Security that can be included in taxable income is 85%,” Vosberg said. “So you’ll always get 15% of your non-taxable profit.”
Combined income includes your adjusted gross income, nontaxable interest, and half of your Social Security benefits. Income that includes interest, dividends, capital gains and distributions from 401(k) or IRAs add to that equation, Vosberg said.
Up to 50% of benefits are taxed for individual filers with combined income between $25,000 and $34,000 and for those who are married filing jointly with combined income between $32,000 and $44,000.
Up to 85% of benefits may be taxable for individuals with more than $34,000 in combined income or married couples with more than $44,000.
Because those thresholds are not adjusted for inflation, more beneficiaries may be subject to tax on their benefits.
As interest rates rise, you may also earn higher interest payments on your cash, which could also increase your combined income, Vosberg said.
One caveat for 2023 is that the IRS has set higher federal tax brackets to adjust for inflation.
Tips to minimize the tax bite
For recipients, now is a good time to plan for their 2023 income to ensure the most tax-efficient income mix, Vosberg said.
For example, if you budget $5,000 in income per month and your monthly Social Security checks are $2,000, you might consider withdrawing money you’ve already paid taxes on for the remaining $3,000. That can include traditional savings or Roth IRA accounts.
“You combine the income and you can effectively control your taxes in retirement,” Vosberg said.
“Many times [that can] reduce the tax you’re paying or even eliminate the tax you’re paying into Social Security,” he said.
To accomplish that, it’s important to have a qualified tax planner, or CPA, said Vosberg.
Early retirees can also benefit from career guidance. By accumulating their after-tax money through savings or Roth conversions in the years leading up to retirement, they can more effectively control their taxable income later, Vosberg said.