Squeezing more

Opportunities for minimizing the taxability of Social Security benefits.

From The Tax Adviser:
Squeezing More From Your Social Security Dollar

F or many years, the methods for minimizing the tax effects of Social Security benefits were limited; given the income thresholds and the available deferral mechanisms, there were little flexibility and few opportunities for significant savings.

This, however, is no longer the case. Recent legislation, as well as certain new investment vehicles, has generated new strategies and opportunities to minimize taxes (and increase added income).

Basic strategies

Minimizing the taxes on Social Security benefits centers on two basic principles: avoiding exceeding the annual earned income limits and minimizing the amounts included in provisional income.

Annual earning limits . As of 1997, Social Security recipients who are 65 to 69 can earn up to $13,500 without triggering a reduction in benefits. (This amount is scheduled to increase annually through 2002.) Those individuals lose $1 dollar in benefits for every $3 earned over the annual limit. For Social Security recipients under age 65, the 1997 limit is $8,640; those recipients lose $1 in benefits for every $2 earned over that amount. There is no earnings limit for recipients 70 and older.

Provisional income . Social Security recipients must include a portion of their benefits in income only if their provisional income exceeds certain thresholds. Provisional income is an individuals modified adjusted gross income (MAGI) plus half of his or her Social Security benefits (or Railroad Retirement Tier 1 benefits). For these purposes, MAGI is adjusted gross income, including exempt interest and excluding certain allowances.

Income thresholds

As noted, a Social Security recipient must include a portion of his or her benefits in income if he or she exceeds one of three thresholds, based on the individuals status: married taxpayers filing separately who do not live apart for the entire year; single taxpayers, heads of households and married taxpayers filing separately who do live apart from their spouses; and married taxpayers filing jointly.

Planning opportunities

Several strategies can minimize the includability of Social Security benefits, including some now available to taxpayers whose income levels were previously thought too high to benefit from such planning. As with most strategies, however, a decision to use any (or all) of these techniques requires consideration of a taxpayers overall financial picture as well as his or her attitude toward risk.

• Stock index funds . Because these funds typically have extremely low asset turnover rates (thereby resulting in minimal capital gain distributions), investing in them may result in including a smaller portion of Social Security benefits in gross income. However, the amounts invested must remain in the funds, thereby reducing an individuals current cash flow.
• Apportioning assets between deferred and nondeferred accounts . Taxpayers who can select specific assets for their retirement accounts may be able to reduce current taxes by allocating investments with higher taxable yields to tax-deferred accounts (such as individual retirement accounts). Just as with stock index funds, the use of this strategy results in less cash available for withdrawals.
• Annuities . While all taxpayers can use annuities to defer the recognition of income, they may be extremely attractive to recipients of Social Security benefits, since, in an annuitys early years, the proceeds typically are characterized as returns of principal (and not interest income).
• U.S. savings bonds . Savings bonds may be used to defer investment income.
• Diversified portfolio . If a taxpayers portfolio includes unrealized capital loss assets, the taxpayer may reduce taxable income by selling those assets and offsetting the loss against other income.
• Maximized contributions to retirement accounts . A qualifying individual may make deductible IRA contributions, even while receiving Social Security benefits, until the tax year he or she reaches age 70 ¹ / ₂ . Qualifying individuals can contribute to Keogh plans and simplified employee pensions even after reaching that age.

For a detailed discussion of Social Security benefits and their inclusion in income, see “Minimizing the Taxability of Social Security Benefits,” by Seth Hammer, in the September 1997 issue of the Tax Adviser .

— Nicholas Fiore, editor
The Tax Adviser