IRS USA METHOD TO DETERMINE YOUR TAXES ON RETIREMENT

The method the IRS uses to determine how you pay taxes on retirement creates a big issue, where taxes can be much greater. You have to pay much higher taxes on your retirement income if you fall in the category set by IRS for high tax payers, which would greatly affect your money. In today’s article we will discuss different options to avoid paying much higher taxes, saving you lot of more money.

HOW TO AVOID PAYING MORE RETIREMENT TAX TORPEDO

When we discuss the issue of retirement tax torpedo, we first must need to know the basics of how Social Security benefits are included as part of your taxable income, because this is the main point of setting off this amplification of taxes. Basically, retirees fall into following three basic categories:

THREE BASIC CATEGORIES   

• In the first category you would not have to pay anything in taxes as this category is non-taxable. While in the second category between 1 and 85% of your benefit is approximately taxable income. Then the category where 85% of your benefit is taxable. Retirement tax torpedo exists in the upper end of the first category through the lower end of the third category.
• So, in the first category where none of your Social Security benefits are taxable, you have no real need to fear falling into the problematic zone unless you have other income that could push you into that second category. However, if you are in the third category, where 85% of your benefits are taxable, the only practical option you have is to somehow lower your income so you qualify for the first or second category and avoid paying huge taxes in third category.
• But if you are in the top of the first category, anywhere in the second category, the bottom of the third category, you may have more control over how much you pay in retirement taxes. So, this is actually a danger zone, because in this zone you almost have to pay double tax on your income. For some people, this high retirement tax torpedo can easily be avoided with a well-thought-out retirement income plan by knowing your numbers. Firstly, you need to calculate your combined income for Social Security purposes.
• This is the number that the social security administration uses to that how much is Social Security benefit is taxable. It is basically referred to as provisional income, but social security administration uses specific term “combined income”. The combined income is calculated as your adjusted gross income plus any tax-exempt interest, like tax-free bonds, plus 50% of your Social Security benefits. So, once knew your combined income, you just need to apply to the threshold tables to determine what percentage, if any, of your Social Security benefits will be included as taxable income. However, if combined income of a single person is less than the base amount of $25,000, none of his/her Social Security benefits will be taxed.

Combined Income

• However, if your combined income is between 25,000 and 34,000, up to 50% of your benefit could be taxed. If your combined income is more than 34,000, up to 85% of your benefits will also likely be taxed. However, if you and your spouse file joint return with a combined income and it is less than the base of 32,000, none of your benefits are taxable. Because of the way Social Security income phases into taxation through this formula, there is a danger zone when every dollar of increase in combined income pulls more Social Security into taxation. In this zone, the effective tax rate on the other income is so high. For instance, if an individual is in the upper end of the danger zone and takes one dollar from his IRA account, they will not only have to pay tax on that one dollar, but also on 85 cents of their Social Security benefit. They took out one dollar, but they had a dollar and 85 cents added to their taxable income.

Married Couple

• In case that a married couple, a husband has a four retirement age social security benefit of $3,000. While wife has a four retirement age benefit of $1,650. Together, they have $4,650 in gross monthly social security. Now, in addition to their social security payments, they take out $2,000 per month in distributions from their IRA. Using this information, we can do a quick calculation and see that every year, this is $24,000 in IRA distributions, and then $55,800 in Social Security benefits. Based on those income numbers, we can run that through a tax calculator and see what the results are. We have the $24,000 IRA distributions, then $55,800 in gross Social Security benefit. But because of their other income, only $12,715 of their social security is taxable.
• Their adjusted gross income is the IRA distributions plus the taxable part of Social Security, which comes up to $36,715. We can then take away the 2023 standard deduction, which is $30,700. They get the extra bump because they’re over 65. This gives them a taxable income of $6,015. When you run that through the federal tax brackets, that gives them a tax liability of $602.

Taking Extra Money from Individual Retirement Account (IRA)

• But let’s change this up slightly and assume that both husband and wife want to take an extra $40,000 from their IRA to buy a new truck. Now, they have about 800,000 in their IRA, so they know this won’t put them at risk of running out of money since they’re only taking out about 3% of their portfolio value. But how would this change things for taxes? Well, let’s look at the numbers and hang on to your hat because this is probably going to shock you. First, we have the $24,000 in IRA distributions, and then we’ll add an additional 40,000 for the purchase of the truck. Then the only other income for the year was the 55,800 in Social Security benefits. When we run this through a tax calculator, we get a much different result.
• In this scenario, we have the IRA distributions of $64,000, but now the taxable amount of their Social Security benefits has increased from $12,715 to $46,715. Their adjusted gross income is just over $110,000, and this means their taxable income is now at $80,015. And all of this drives up their tax liability to $9,162. So how did taking out $40,000 from their IRA result in their taxable income increasing by $74,000?
• And their tax liability is 1,400 % higher. Well, this goes back to how your Social Security benefit is taxable on a graduated scale. As your income increases, so does the amount of your benefit that’s taxable. And in this case, the additional $40,000 in the IRA distribution caused an additional $34,000 of their Social Security benefit to be counted as taxable income. In this case, for every dollar that came out of their IRA, their taxable income increased by a dollar and 85 cents. This is the retirement tax torpedo. Now, this may be avoidable, though, and there are a few ways to get around it, but much of this will depend on the type of retirement accounts you have, any other retirement income sources, and the amount of income you need while you’re living in retirement. But broadly speaking, here are a few ways that may help you lower the effect of the retirement tax torpedo.
• In many circumstances, there are opportunities for planning around this danger zone and avoiding having more of your hard-earned money go to the IRS. For example, if you still have some time before retirement, you may ought to consider using a Roth IRA.
• This is possibly the most valuable tool for planning around tax on Social Security because distributions from a Roth are not counted in your combined income. If you think you may eventually be in this danger zone, you should consider building a pool of money in your Roth account. You may be able to contribute to a Roth IRA while you’re still working up to $6,500 per year, and that’s $7,500 if you’re over the age of 50. And if your income is too high, you may be able to use a backdoor Roth if your assets are all in the right account types. You may also want to check with your retirement plan at work as well to see if they offer a Roth option.

FAQs

Q. How Does IRS determine how much you have to pay in Taxes?

A. If your income falls in high tax category you have to pay more in taxes. This can range from 50 to 80 percent depending on your income.

Q. HOW TO AVOID PAYING MORE ON RETIREMENT TAX

A. There are penalty of tax deductions available to people who save for retirement, including contributing to a 401 k, Roth 401 k, IRA, Roth IRA and avoiding early withdrawal penalty.

Q. What is the Average Combined Income in USA?

A. The average household income in the United States is around $67,000, however, most states between $50,000 to 90,000.

Conclusion

There is no exact fixed tax on all individuals as tax varies person to person and to specific categories. If you fall in a high income category the tax amount will be greater, which could increase up to 85% if you are high earner. There are different options to avoid paying more in taxes by adopting simple strategies including contributing to a retirement account, including 401 (k) or individual retirement account could help you reducing your taxes.

This is how IRS determine your tax on income.