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Retirees who depend on Social Security benefits for their income will get some relief from record-high inflation when an 8.7% cost-of-living adjustment comes into effect next year.
But two factors — the size of Medicare Part B premiums and taxes on benefits — may offset how much larger those monthly checks will be in 2023.
The good news is that the standard monthly Medicare Part B premium, which covers outpatient and medical coverage, will fall 3% over the next year from the current $170.10 to $164.90. Since these premiums are typically deducted directly from benefit checks, a lower rate allows more beneficiaries to see the cost of living adjustment increase, or COLA.
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However, the higher COLA could put some beneficiaries in a higher tax bracket.
According to Brian Vosberg, a certified financial planner and enrolled agent who is president of Vosberg Wealth in Glendora, Calif., record-high COLA is “great” for retirees as they struggle with higher prices on everything from rent to groceries to gas.
“Even though they’re excited about the hike that’s coming, they don’t really envision the impact it can have from a tax perspective, and then the tax perspective trickles down to their other expenses in retirement,” Vosberg said.
How social benefits are taxed
Social Security benefits are taxed based on a formula known as “combined” or “provisional” income.
This is calculated by taking your adjusted gross income and adding tax-free interest and half your Social Security benefits.
Taxes on Social Security benefits apply to single taxpayers with a combined income of $25,000 or more and for married taxpayers with a combined income of $32,000 or more.
Individuals with combined incomes between $25,000 and $34,000 pay taxes on up to 50% of their benefits. The same goes for married couples who make between $32,000 and $44,000.
Individuals with combined incomes over $34,000 and couples over $44,000 may be taxed up to 85% of their Social Security benefits.
Because the thresholds aren’t adjusted for wage growth or inflation, this has encouraged more Social Security recipients to pay taxes on their benefits over time, according to the Center for Retirement Research at Boston College.
When taxes on benefits were first introduced in 1983, only 8% of eligible families paid taxes on benefits. In 2021, that had increased to an estimated 56%, according to the Center for Retirement Research. With moderate inflation, this is expected to rise to 58% by 2030.
“If inflation rises faster, Social Security benefits will nominally be even higher, and more families will pay for more benefits — further reducing the net benefit,” wrote Alicia Munnell, director of the Center for Retirement Research, and research associate Patrick Hubbard.
How beneficiary taxes may increase in 2023
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According to Joe Elsasser, a CFP and founder and president of Covisum, a provider of software for applying for Social Security, next year’s increases in Social Security income may not give beneficiaries the opportunity to increase their pensions without tax consequences.
For example, if tax brackets increase by about 7%, beneficiaries might believe they can take 7% more from their individual retirement account next year and achieve the same tax results.
“That’s not the case because a larger amount of Social Security is taxable,” Elsasser said.
However, according to Elsasser, there may be scope for some beneficiaries to increase their pension benefits without incurring tax liability on their benefits.
For example, a couple who are both over the age of 65 and who receive $35,000 in Social Security benefits this year can claim $23,967 in withdrawals in 2022 and pay no federal income tax, according to Elsasser’s calculations.
Don’t wait to see your CPA by April 15; it is too late.
Brian Vosberg
President of Vosberg Wealth
In 2023, this couple’s Social Security benefit would increase to $38,045 with the COLA, and the amount they would withdraw could be as high as $24,793, Elsasser said.
If the couple’s Social Security benefits were $60,000 instead, they could withdraw $18,703 tax-free, which would mean up to $65,220 in benefits and a little less — $18,585 — in potential withdrawals in 2023.
Of course, results will vary based on an individual’s or couple’s individual financial situation.
Beneficiaries given the choice of where to withdraw their additional income should re-evaluate that choice each year to achieve the best tax outcomes, Elsasser said.
What you can do to minimize your tax burden
Experts say the goal is to find a mix of retirement income that works for your personal situation and keeps your total or combined income below certain limits.
If you have money saved in both retirement and other accounts, you may be able to create an estimate by using tax software and varying the amount of IRA withdrawals, Elsasser said.
“But that’s definitely the territory of tax-focused financial planners,” Elsasser said.
Whatever your budget, you should figure out where that income will come from by Jan. 1, according to Vosberg.
“Don’t wait until April 15 to see your CPA; it’s too late,” Vosberg said. “The income you’ve already received is pretty much set in stone.”
Beneficiaries who continue with the status quo of pension payments and bank interest could be paying more taxes by the end of next year if they’re not proactive, he said.
To minimize your tax burden, try to make withdrawals from non-taxable sources of income, such as B. Roth individual retirement accounts, Vosberg said.
When the Federal Reserve’s rate hikes go into effect, it would be wise to also pay attention to how much interest you might be earning on savings, including money market accounts and certificates of deposit, which can increase your income, he said.
Keep in mind that higher income due to Social Security COLA can also affect how much you pay for health insurance, Vosberg said.
Those under 65 who are insured under the Affordable Care Act may see their subsidy or premium credits drop. Those who are on Medicare could have higher Medicare B and D supplements.