In a recent episode of her "Women & Money" podcast, a listener asked Suze Orman to breakdown the Social Security tax torpedo so retirees can better understand how to strategize their retirement savings.
Also called the Social Security "tax trap," the tax torpedo occurs when retirees encounter a cascade of tax consequences for their income and various retirement savings withdrawals. This adds up to a point where Social Security benefits become taxable. Depending on your income, up to 85% of your benefits could be taxable.
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According to the Social Security Administration (SSA), about 40% of people who receive Social Security must pay federal income taxes. The amount that people are taxed varies based on their combined income. Combined income refers to an individual or married couple's adjusted gross income, nontaxable interest, and half their social security benefits.
When retirees start receiving Social Security benefits and collecting from retirement accounts, their combined income can increase to the point where they have to start paying taxes on those benefits – and that's the Social Security torpedo.
Orman explains that the torpedo occurs when people get older and have to withdraw money from their traditional retirement accounts. Those required minimum distributions (RMDs) count toward income and can make their Social Security taxable.
She says that Roth IRAs are great for avoiding the Social Security tax torpedo. "If they had a Roth retirement account, there are no RMDs, and any money you take out of a Roth doesn't go toward the taxation of Social Security."
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According to Orman, retirees can keep more of their Social Security income tax-free by focusing on Roth IRAs or Roth 401(k)s.
Orman isn't the only financial expert who has shared this tip. William Reichenstein, a retired Baylor University professor and Social Security expert working for T. Rowe Price, says the best way to avoid the tax torpedo is to do Roth conversions early on during retirement when you're in a low tax bracket. After collecting your Social Security benefits, you can withdraw the money from the tax-free Roth account and minimize the tax torpedo.
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Reichenstein also says, "By the way, that's a federal-alone income tax. If you're in a state that charges income tax, it's going to be higher than that." So, those living in states subject to income taxes will have even more of a tax burden with this Social Security torpedo.
If you're still planning for retirement, Orman's advice is simple: "The best way to prepare for it is to have only Roth retirement accounts. Bar none." By prioritizing Roth accounts, you can avoid, or at least minimize, the tax torpedo and keep more of your Social Security benefits.
However, Roth IRAs might not be the best choice for everyone. Your current tax situation, expected retirement income, and personal financial goals all play a role in deciding what's right for you. Some experts suggest a mix of Roth and traditional accounts to give you more retirement options.
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