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Social Security recipients are just beginning to see a record cost-of-living adjustment of 8.7% in their monthly checks.
But when tax time comes, they could see surprises stemming from last year’s 5.9% increase, which at the time was the largest cost-to-use (COLA) increase in four decades.
A cost-of-living adjustment of 5.9% last year was like getting a 6% wage increase in 2022, according to Marie Johnson, Social Security and Medicare policy analyst at the Senior Citizens League. However, this increase in benefits hasn’t been enough to keep up with rising costs, according to recent research from a large, nonpartisan group.
A recent survey by the Senior Citizens League found that 57% of older taxpayers are concerned that more of their Social Security benefits will be taxed because of last year’s 5.9% cost-of-living adjustment. The survey, which was conducted last summer, included about 1,500 respondents.
“There are a huge number of people involved,” Johnson said.
More Social Security beneficiaries may be required to file tax returns this season, but it’s likely to be “a relatively small number,” predicts Paul Van de Water, a senior fellow at the Center for Budget and Policy Priorities.
For beneficiaries who file, higher benefit income may be partially offset by a larger standard deduction and indexation of tax brackets, he said.
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The new 8.7% cost-of-living adjustment that went into effect this month could make tax planning more complicated 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-filing season, according to Brian Vosberg, a certified financial planner, registered agent and president of Vosberg Wealth in Glendora, California.
“Once December 31st rolls around, there’s not much you can do to reduce your tax liability,” Vosberg said.
One exception is if you made the previous year’s contribution to an individual retirement account before April 15, which could help reduce your taxable income.
However, recipients would be wise to jump in next year’s tax planning to mitigate the effects of the 8.7% cost-of-living adjustment.
How are Social Security benefits 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 the benefit untaxed.”
Combined income includes adjusted gross income, nontaxable interest, and half of your Social Security benefits. Income including interest, dividends, capital gains and distributions from 401(k) or IRAs all add up to that equation, Vosberg said.
Up to 50% of the benefits are taxed for single tax filers with a combined income of $25,000 to $34,000, who are married and file together with between $32,000 and $44,000 in combined income.
Up to 85% of benefits may be taxable for individuals with more than $34,000 in combined income or married couples with incomes over $44,000.
Because these thresholds are not adjusted for inflation, more recipients may be subject to taxes on their benefits.
As interest rates rise, you may also get higher interest payments on your money, Vosberg said, which can also increase your combined income.
One caveat for 2023 is that the IRS has instituted higher federal tax brackets to adjust for inflation.
Tax reduction tips
For recipients, Vosberg said, now is the time to plan for their income in 2023 to ensure the most tax-efficient income mix.
For example, if you’re budgeting for an income of $5,000 per month, and your monthly Social Security checks are for $2,000, you might look to withdraw the money you’ve already paid tax on the remaining $3,000. This may include traditional savings or Roth IRAs.
“You can blend income and you can effectively control your taxes in retirement,” Vosberg said.
“A lot of the time [that can] Reducing the taxes you pay or even eliminating the tax you pay on Social Security.”
To achieve this, it’s important to get into a qualified tax planner, or CPA, Vosberg said.
Retirees can also benefit from career guidance. By building up their after-tax money through savings or Roth transfers in the years leading up to retirement, Vosberg said, they may take more effective control of their taxable income later on.