How to Avoid Paying Taxes on Your Social Security

How Can I Avoid Paying Taxes on Social Security? – SmartAsset

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Social Security benefits can provide an additional income stream in retirement alongside withdrawals from a 401(k), individual retirement account or brokerage account. Part of shaping a retirement plan around Social Security income means planning ahead for taxes. Social Security benefits are considered taxable for some retirees, though whether yours are can depend on your income. If you’re wondering, how you can avoid paying taxes on Social Security, there are some strategies you can try.

Do you have questions about your overall tax situation? Speak with a financial advisor today.

When Are Social Security Benefits Taxable?

Generally, Social Security benefits are only taxable when your income reaches certain thresholds. Those thresholds vary, based on your tax filing status. The amount of your benefits that are taxable depends on both.

For Social Security to be tax-free, your annual combined income must be:

  • Below $25,000 if you’re a single filer
  • Below $32,000 if you’re married and file a joint tax return

The Social Security Administration considers combined income to be the total of your adjusted gross income, not counting Social Security income, tax-exempt interest and 50% of your Social Security income.

If your income is above the threshold specified for your filing status, there’s a second test that determines how much taxes you’ll pay on Social Security benefits. Specifically, you may be subject to one of two tax rates:

  • Up to 50% of your benefit is taxable if you’re a single filer with a combined income between $25,000 and $34,000
  • Up to 85% of your benefit is taxable if you’re a single filer with a combined income above $34,000
  • Up to 50% of your benefit is taxable if you’re married filing jointly with a combined income between $32,000 and $44,000
  • Up to 85% of your benefit is taxable if you’re married filing jointly with a combined income above $44,000

It’s worth noting that if you’re married but file separate returns, the Social Security Administration says you’ll most likely pay taxes on your benefits.

How Can I Avoid Paying Taxes on Social Security?

If you believe your income will put you over the threshold and require you to pay taxes on Social Security benefits, there are a few things you can do to potentially minimize what you owe. You may only have to worry about this, however, if your adjusted gross income would put you over the limit. Remember that for tax purposes, adjusted gross income (AGI), which is your gross income that accounts for certain deductions (which usually make it lower than your gross income), includes:

  • Wages earned from a job
  • Self-employment earnings
  • Interest earnings
  • Dividends
  • Required minimum distributions (RMD) from qualified retirement accounts, such as a 401(k) or traditional IRA

If you have any types of taxable income that would affect your AGI calculation, the first thing you could try and avoid taxes on Social Security is to contribute to tax-advantaged accounts. Specifically, that includes Roth accounts.

Roth IRAs and Roth 401(k) accounts allow for 100% tax-free distributions in retirement. A Roth IRA is also exempt from required minimum distributions starting at age 72. Withdrawals made in retirement from a Roth IRA wouldn’t affect your AGI calculations when determining which part of your Social Security benefits, if any, are taxable. If you already have a traditional 401(k) at work, you could use a Roth IRA to help offset some of your tax liability in retirement.

You could also consider a Roth IRA conversion if your assets are currently held in a traditional IRA. This allows you to essentially swap your current IRA for a Roth version, allowing you to tap into the benefit of tax-free withdrawals in retirement. But there’s a catch. You’ll owe income tax on any amounts you convert at the time the conversion happens.

Another option for minimizing Social Security taxes is to draw down taxable income as much as possible before taking benefits. Remember, the earliest age at which you can begin taking Social Security is 62. But if you have a 401(k) or IRA, you can begin taking money from those accounts without facing a tax penalty starting at age 59.5.

If you have money in a traditional 401(k) or traditional IRA, you may consider taking money out of those accounts before taking Social Security benefits. That way, you can pay the tax on those amounts and they won’t be factored in for AGI calculations since you’ll have already withdrawn them. You could then put the money into a taxable brokerage account so it can continue to be invested and grow over time.

While RMDs are unavoidable, barring a steep tax penalty, you can take steps to minimize what counts as income. For example, you can withdraw up to $100,000 from a traditional IRA and donate it to charity, with the withdrawn amount counting toward your RMD for the year.

You may also be able to defer RMDs and thus avoid paying tax on Social Security benefits using a qualified longevity annuity contract or QLAC. You can put up to $135,000 in IRA funds into a QLAC and defer taking required minimum distributions up to age 85. At the same time, the QLAC could make income payments back to you, though that can have its own tax implications.

Should You Avoid Paying Taxes on Social Security Benefits?

You might be focused on how to avoid paying taxes on Social Security but it’s important to consider whether you should.

For example, say your initial goal is to begin taking benefits at age 62 while continuing to work part-time. Doing so would mean having to keep a close eye on your income from part-time work to ensure that you don’t tip the threshold for having your benefits taxed. You’d also have to observe the annual earnings limits to avoid having your benefit amount reduced.

It’s worth noting also that taking Social Security prior to reaching your full retirement age would reduce your benefit amount. So, by working and receiving benefits early, you could effectively ding yourself financially three times over through benefit reductions and having to pay taxes on them.

When determining ways to avoid paying taxes on Social Security, it’s important to consider the bigger tax picture. That includes where withdrawals from both tax-advantaged retirement accounts and taxable brokerage accounts fit in. It’s also important to consider your timing when taking benefits. If you’re able to delay Social Security to age 70, for example, you could get 132% of your benefit amount.

Moving money from a taxable account, such as an IRA, to a brokerage account can also trigger problems. While your money can still be invested and grow, you’ll now be subject to capital gains tax on any profits you realize when selling investments. You could use tax-loss harvesting to offset gains with losses you may not escape taxes entirely. Talking to a financial advisor and/or a tax planning professional can help you decide which route to take as you approach Social Security benefits.

The Bottom Line

Social Security benefits are taxable for some, though not all, retirees. If you anticipate having to pay taxes on your benefits in retirement, the time to start planning for that eventuality is now. Just keep in mind that there are some reasons why you may not want to avoid paying taxes on Social Security benefits. By taking proactive measures to mold your financial plan, you can minimize your overall tax liability.

Tips on Taxes

  • Consider talking to a financial advisor about where Social Security benefits fit into your retirement income plans. If you don’t have a financial advisor yet, finding one doesn’t have to be difficult. SmartAsset’s financial advisor matching tool can help you connect with professional advisors in your local area. It takes just a few minutes to get your personalized advisor recommendations online. You can then decide which advisors you’d like to connect with. If you’re ready, get started now.
  • If you’re not retired or receiving benefits yet, you can use a Social Security calculator to estimate how much you might be eligible for. You could then use that number to create a plan for managing taxes on Social Security benefits.

Photo credit: ©iStock.com/BackyardProduction, ©iStock.com/Kriangsak Koopattanakij, ©iStock.com/Jorge Villalba

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She’s worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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Wealth Tax: Definition, Examples, Pros and Cons

Wealth Tax: Definition, Examples, Pros and Cons – SmartAsset

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A wealth tax is a type of tax that’s imposed on the net wealth of an individual. This is different from income tax, which is the type of tax you’re likely most used to paying. The U.S. currently doesn’t have a wealth tax, though the idea has been proposed more than once by lawmakers. Instituting a wealth tax could help generate revenue for the government but only a handful of countries actually impose one.

Wealth Tax, Definition

A wealth tax is what it sounds like: a tax on wealth. This can also be referred to as an equity tax or a capital tax and it applies to individuals.

More specifically, a wealth tax is applied to someone’s net worth, meaning their total assets minus their total liabilities. The types of assets that may be subject to inclusion in wealth tax calculations might include real estate, investment accounts, liquid savings and trust accounts.

A wealth tax isn’t the same as other types of tax you’re probably familiar with paying. For example, you might be used to paying income tax on the money you earn each year, self-employment tax if you run a business or work as an independent contractor, property taxes on your home or vehicles and sales tax on the things you buy.

Instead, a wealth tax has just one focus: taxing a person’s wealth. According to the Tax Foundation, only Norway, Spain and Switzerland currently have a net wealth tax on assets. But a handful of other European countries, including Belgium, Italy and the Netherlands, levy a wealth tax on selected assets.

How a Wealth Tax Works

Generally, a wealth tax works by taxing a person’s net worth, rather than the income they earn in a given year. In countries that impose a wealth tax, the tax is only levied once assets reach a certain minimum threshold. In Norway, for instance, the net wealth tax is 0.85% on stocks exceeding $164,000 USD in value.

Wealth taxes can be applied to all of the assets someone owns or just some of them. For example, the wealth tax can include securities and investment accounts while excluding real property or vice versa.

Every country that imposes a wealth tax, whether it’s a net tax or a tax on selected assets, can set the tax rate differently. It’s not uncommon for there to be exemptions or exclusions to who and what can be taxed this way.

A wealth tax can be charged alongside an income tax to help generate revenue for the government. The wealth tax rates are typically lower than income tax rates, in terms of the actual percentage rate, but that doesn’t necessarily mean paying less in taxes. Someone who has substantial assets that are subject to a wealth tax, for instance, may end up paying more toward that tax than income tax if they’re able to reduce their taxable income by claiming tax breaks.

Is a Wealth Tax a Good Idea?

In countries that use a wealth tax, the revenue helps to fund government programs and organizations. In some places, such as Norway, revenue from the wealth tax is split between the central government and municipal governments. It would be up to the federal government to decide how wealth tax revenue should be allocated if one were introduced here.

In the U.S., the concept of a wealth tax has been used to argue for a redistribution of wealth. Or more specifically, lawmakers who back the tax have suggested that it could be used to more fairly tax the wealthy while relieving some of the tax burdens on lower and middle-income earners. While wealthier taxpayers may take advantage of loopholes to minimize income taxes, a wealth tax would be harder to work around, at least in theory. That could yield benefits for less wealthy Americans if it means they’d owe fewer taxes.

That sounds good but implementing and collecting a wealth tax may be easier said than done. It’s possible that even with a wealth tax in place, high-net-worth and ultra-high-net-worth taxpayers could still find ways to minimize the amount of tax they’d owe. And the tax itself could be seen as unfairly penalizing wealthier individuals who own charities or foundations, invest heavily in businesses or save and invest their money instead of using it to buy things like luxury cars, expensive homes or other physical assets.

It’s important to keep in mind that a wealth tax is targeted at people above certain wealth thresholds, so most everyday Americans wouldn’t have to pay it. But it could cause problems for someone who unexpectedly receives a large inheritance that increases his wealth, even if his income remains at the lower end of the scale.

The Bottom Line

In the U.S., the wealth tax is still just an idea that’s being floated by progressive politicians and lawmakers. Whether a wealth tax is ever implemented remains to be seen and it’s likely that debate over it may continue for years to come. And enforcing one could be difficult if it were ever introduced, if for no other reason than there are many ways for the extremely wealthy to avoid taxes. In the meantime, talking with a tax professional may be the best way to manage your own personal tax liability.

Tips on Taxes

  • Consider talking to your financial advisor about the best ways to handle taxes as you grow an investment portfolio. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s financial advisor matching tool can help you connect with professional advisors online. It takes just a few minutes to get your personalized financial advisor recommendations. If you’re ready, get started now.
  • Managing taxes is an important part of growing wealth and creating an estate plan. The less you pay in taxes, the more money you have to save and invest toward establishing a legacy of wealth. A free income tax calculator is a good way to start figuring what you owe or to get confirmation that  your calculations are correct.

Photo credit: ©iStock.com/Serhii Sobolevskyi, ©iStock.com/svengine, ©iStock.com/FG Trade

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She’s worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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A Comprehensive Guide to 2020 Tax Credits

A Comprehensive Guide to 2020 Tax Credits | SmartAsset.com

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Every year, people’s lives change in ways that affect their taxes. They may start a higher education program or have a child, and others take on elderly parents as dependents. These situations can change their eligibility for tax credits. In addition, federal, state and local governments sometimes adjust rules about credits, so it is crucial to understand what credits you can take. Navigating the world of tax credits and deductions can be confusing. That is why a trusted financial advisor can help you find every tax credit you are entitled to.

What a Tax Credit Is (and Isn’t)

Tax credits encourage people to spend money by giving them credit toward that expense. For example, one of the most common tax credits is the Child Tax Credit. Taxpayers who have children under the age of 17 receive a credit to help reduce the cost of raising a child. Another popular tax credit is the Lifetime Learning Credit (LLC). The LLC encourages people to pursue further education by crediting part of the overall cost back at tax time.

A tax deduction lowers one’s taxable income, thus reducing the tax liability. If a person receives a deduction, he decreases the amount from his income, which lowers his taxable income. The lower a person’s taxable income, the lower the tax bill.

By contrast, a tax credit decreases the tax bill rather than a person’s taxable income. So, if a person has a $100,000 salary and has a $10,000 deduction, the taxable income will be $90,000. If the person in this example is taxed at a rate of 25%, the tax bill will be $22,500. If that same person has a $10,000 credit instead of a deduction, he will be taxed at 25% of their $100,000 income and owe $25,000 in taxes. However, he will then be credited $10,000 and owe only $15,000.

Some tax credits are refundable, but most are not. A refundable tax credit, which is different from a tax refund, can be given to taxpayers even if they do not owe any taxes. Additionally, a refundable tax credit can be given in addition to a tax refund. A nonrefundable tax credit means that a person will get the tax credit up to the amount owed. For example, if a person owes $2,000 in taxes and receives $3,000 in nonrefundable credits, that will simply erase her tax bill. If she gets $3,000 in refundable credits, she will receive a $1,000 tax refund.

Some common tax credits for individuals include:

  • Child Tax Credit
  • Earned Income Tax Credit
  • Credit for Other Dependents
  • Adoption Credit
  • Low-Income Housing Credit
  • Premium Tax Credit (Affordable Care Act)
  • American Opportunity Credit
  • Lifetime Learning Credit

Child Tax Credit

The Child Tax Credit is a refundable credit up to $1,400 and offers up to $2,000 per qualifying child age 16 or younger. Parents of children who are 16 or younger as of Dec. 31, 2020, can qualify for this tax credit. For someone to be eligible for the Child Tax Credit, the modified adjusted gross income must be under $400,000 if the parents of the child(ren) file jointly and $200,000 for any other person filing.

Additional requirements to qualify for the child tax credit include that the person filing must have provided at least half of the child’s support in the calendar year, and the child must have lived with the person filing for at least half the year. There are some exceptions to this rule, and it is best to discuss the child tax credit with a tax advisor.

Child and Dependent Care Credit

The cost of childcare, eldercare and other in-home care in the U.S. is high and tends to rise each year. If a couple is married and files jointly and has paid expenses for the care of a qualifying child or dependent so that one or both can work, they are likely eligible for the Child and Dependent Care Credit.

To qualify for the Child and Dependent Care Credit, the taxpayers must have received taxable income. This is because the credit is designed to help individuals who need to hire a caretaker to stay in the workplace.

Additionally, there are several qualifiers on the person being cared for. A child must be under age 13 when the care was provided. A qualifying spouse must be unable to take care of himself and have lived in the taxpayer’s home for at least half the year. A qualifying dependent must be physically or mentally incapable of caring for himself, have lived with the taxpayer for at least half the year and is either a dependent or could have been a dependent of the taxpayer. A taxpayer can claim up to $3,000 of expenses for one child or dependent and up to $6,000 for two or more children or dependents.

There are limits on who can provide care to qualify for this tax credit. The caregiver must not have been the taxpayer’s spouse, a parent of the child being cared for or anyone else listed as a dependent on the tax return. Additionally, the caregiver can’t be a child of the taxpayer.

Any child support payments you’ve received won’t be counted as taxable income. And if you’re the one making the child support payments, the income you used to do so won’t be tax deductible.

Federal Adoption Credit

Families that grow through adoption might be eligible for the Federal Adoption Tax Credit. Adoption can be an expensive process, and as families take on the burden of legal fees and more, the Federal Adoption Credit can help to decrease the burden when filing taxes.

To be eligible for the full credit, adoptive parents must earn $214,520 or less, regardless of their filing status. The credit is up to $ 14,300 per eligible child. An eligible child is any person under the age of 18 that is mentally or physically unable to take care of themselves. Eligible expenses include court costs, attorney fees, home studies and other travel expenses related to the adoption. The Federal Adoption credit is nonrefundable, so it will not produce a refund.

There are several rules for the Federal Adoption Credit, so it is important to speak with your tax advisor before claiming this credit. For example, if you received employer-provided adoption benefits, you may not claim the same expenses that were covered by your employer for the Federal Adoption Credit.

Credit for Other Dependents

The Credit for Other Dependents is a tax credit available for taxpayers who do not qualify for the Child Tax Credit. For example, someone who has a child age 17 or older or has other adult dependents with an Individual Taxpayer Identification Number might qualify for this credit. This tax credit amount is $500 for each dependent that qualifies for the tax credit. The credit is available in full to a taxpayer who earns $200,000 or less and decreases on a sliding scale as that person’s income increases.

An example of someone eligible for the Credit for Other Dependents is a single person filing who has a child dependent that is 17 years old and another child who is 21 and in college. Both children would likely qualify as dependents, and each would be eligible for the $500 credit. Another example is if someone has an adult relative living with him listed as a dependent on his tax return. In any case, the dependent must be a U.S. citizen, national or resident alien.

Lifetime Learning Credit

To promote education in the United States, the IRS created a tax credit called the Lifetime Learning Credit (LLC). This credit is for qualified tuition and expenses paid for qualified students at qualified institutions in the United States.

To claim the LLC, a person, their spouse or their dependent must pay qualified higher education expenses. Additionally, the student must be enrolled at an eligible educational institution. Eligible educational institutions are colleges, technical schools and universities offering education beyond high school. All qualified educational institutions are eligible to participate in a student aid program run by the U.S. Department of Education. The IRS publishes a list for people to search if their school is a qualified educational institution.

To receive the LLC, a person must have received a 1098-T tuition statement from the higher education institution. The credit is worth 20% of the first $10,000 that a person spends at the higher education institution. For example, if a person started school at a university in the fall semester and tuition cost $10,000 or more, that person would receive a credit of $2,000. The LLC is not refundable, so a person can use the credit for taxes who owe but will not receive the credit as a refund.

Additionally, the LLC has income limits. In 2020, a person’s income must be $69,000 or lower if filing single and less than $138,000 if filing jointly to receive any of the LLC. To be eligible for the full LLC amounts, a person can earn up to $118,000 filing jointly or $59,000 filing single.

The Retirement Contribution Savings Credit

The Saver’s Credit, or the Retirement Contribution Savings Credit, has been around since the early 2000s. It was created to help low- and moderate-income individuals save for retirement. Depending on a taxpayer’s income, the Saver’s Credit is worth 10%, 20% or 50% of her total savings contribution up to $1,000, or $2,000 if a person is filing jointly.

For example, if a person is filing single, her income qualifies her for the 50% credit tier, and if she contributes $2,000 to an IRA, she can receive a credit of $1,000. The maximum credit is $1,000, so if the same person decides to contribute $2,500 to an IRA, she will still receive a $1,000 tax credit.

Earned Income Tax Credit

An Earned Income Tax Credit (EITC) reduces the tax bills for low- to moderate-income working families. The credit ranges from $538 to $6,660 depending on a taxpayer’s filing status, how many children they have and their earned income. This amount changes every year, so be sure to verify the EITC with a tax advisor or verify with the IRS.

To qualify for the EITC, a taxpayer must have earned taxable income from a company, running a farm or owning a small business. People who do not earn an income, are married filing separately or do not have a Social Security number are not eligible for this credit. Additionally, people who earned over $3,650 in investment income are ineligible for this tax credit.

To earn the maximum EITC, a single filer can earn $50,594 or less, and a joint filer can earn $56,844 or less and have three or more dependent children. The amount of the EITC credit decreases if a taxpayer has fewer children.

American Opportunity Tax Credit

The American Opportunity Tax Credit (AOTC) is available to eligible students in the first four years of higher education. Students must be pursuing a degree or other recognized credential, be enrolled at least half time for at least one academic period or semester, not have received the AOTC or the Hope credit for more than the past four years and not have a felony drug conviction at the end of the tax year.

Students may receive up to $2,500 of credit for the AOTC. The credit is refundable up to 40%, so if a student is eligible for the full $2,500 and receives a tax return, the student can receive up to $1,000. The credit is awarded for 100% of the first $2,000 of qualified educational expenses and 25% of the next $2,000 of educational expenses. Therefore, if a student pays at least $4,000 in educational expenses, he will receive the full $2,500.

To prove they are eligible, students must receive a 1098-T from their educational institution. A taxpayer’s modified adjusted gross income must be $80,000 or less, or $160,000 or less for a married couple filing jointly to receive the full AOTC. If the student is a dependent, the taxpayer may claim the AOTC when filing taxes.

An example of someone claiming the AOTC is a parent who earns $79,900 and has a student in the first four years of a degree program. Another example of someone eligible is a student who is not a dependent of anyone and works part-time, earning $80,000 or less. If you are unsure if you or your family qualifies for this tax credit, be sure to speak with a tax advisor.

The Takeaway

There are many tax credits that American taxpayers can take advantage of. These credits were created to encourage spending in specific areas of the economy and help low- and moderate-income families prosper. In addition to tax credits, there are plenty of other ways to keep more money in your pockets during tax season. Be sure to check out the IRS website to learn more about other tax credits, including the Residential Energy Efficient Property Credit, Foreign Tax Credit and more.

Tips on Taxes

  • Navigating the world of tax deductions and credits can be cumbersome and confusing. That is why it is so valuable to work with a financial advisor. Finding one doesn’t have to be difficult. SmartAsset’s matching tool can connect you with several financial advisors in your area within minutes. If you’re ready, get started now.
  • Using a free tax return calculator can help confirm that you did your arithmetic correctly … or indicate that you may have missed a credit or deduction.

Photo credit: ©iStock.com/grejak, ©iStock.com/Ridofranz, ©iStock.com/Pgiam

Ashley Chorpenning Ashley Chorpenning is an experienced financial writer currently serving as an investment and insurance expert at SmartAsset. In addition to being a contributing writer at SmartAsset, she writes for solo entrepreneurs as well as for Fortune 500 companies. Ashley is a finance graduate of the University of Cincinnati. When she isn’t helping people understand their finances, you may find Ashley cage diving with great whites or on safari in South Africa.
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