Taxes in retirement can take a big bite out of the money you have available to you. If you have a traditional IRA or 401(k), you’ll typically be taxed on withdrawals as ordinary income. And if your countable income exceeds a certain threshold, you could even find yourself being subject to tax on up to 85% of your Social Security benefits.
The good news is, you may have an unprecedented opportunity in 2020 to reduce the amount you owe the IRS. This comes courtesy of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, although not everyone can take advantage of it.
How the CARES Act allows you to reduce your taxes on Social Security in 2020
The CARES Act could help you to reduce or avoid taxes on Social Security benefits for one simple reason: It waives the requirement that you take required minimum distributions (RMDs) from your 401(k) or traditional IRA accounts this year.
Normally, RMDs are required once you hit age 72 (or 70 1/2). Life expectancy tables from the IRS dictate the amount you’re required to withdraw each year and you’re subject to a penalty of 50% of the amount of your RMD if you don’t take it. And, for many people, these RMDs give them enough income to render their Social Security benefits at least partially taxable.
That’s because the Social Security Administration determines how much you owe in taxes on your retirement benefits based on “countable income” and that’s defined to include half of your Social Security check as well as all taxable income including retirement account distributions.
Once your countable income hits $32,000 if you are married and file jointly, or $25,000 for other tax filing statuses, you will face taxes on at least some portion of your benefits. Specifically:
- Married joint filers who have incomes between $32,000 and $44,000 owe taxes on up to 50% of benefits. With incomes above $44,000, a married couple may be taxed on up to 85% of benefits.
- Other tax filers with incomes between $25,000 and $34,000 could be taxed on up to half of benefits and those with incomes above $34,000 could see up to 85% of their benefits subject to taxation
If you are making withdrawals from tax-advantaged accounts in order to fulfill your RMD requirements and the money you take out puts your countable income above these limits, there’s normally nothing you can do about it — you have to just pay the tax bill due because otherwise you’d owe penalties for not taking your required distributions.
But this year, since the CARES Act waives the RMD requirement, you could opt to take a smaller amount of money from your retirement accounts. With less countable income, you could avoid going above the threshold at which your benefits become subject to tax, thus saving yourself from a big IRS bill.
Of course, if you don’t take an RMD this year, you’d also save on the taxes you’d normally owe on your distribution, which is taxed as ordinary income. So the savings would come not just from avoiding taxes on Social Security, but also from not owing this money to the IRS either.
Should you skip your RMDs to keep your tax bill low?
If you need to take money out of your tax-advantaged retirement accounts to fund your living expenses, then the fact RMDs are suspended for this year may not help you much — after all, you’ll be making withdrawals anyway.
But if you have other sources of funds or can live on less and you don’t need to withdraw money, the CARES Act has provided an unprecedented opportunity to avoid a substantial amount of taxes this year and to keep more of your Social Security checks.
This likely will be your only chance to avoid RMDS without owing the customary 50% penalty, so if you can make it work for a year, it may be worth doing.