The Stealth Way Social Security Has Been Robbing Seniors of Their Benefits for Years

Social Security is a critical income source for millions of seniors, and while you’ll often hear that it’s not advisable to live on those benefits alone, the reality is that many seniors do. But some people do a good job of saving for retirement and securing other income streams. As such, their benefits represent just a portion of their total senior income.

That’s really a more ideal situation. But seniors with outside income take one big risk — getting taxed on their Social Security benefits. And worse yet, the rules regarding those taxes haven’t changed in years, and seniors often feel the pain because of that.

An outdated set of guidelines

Seniors who don’t have income outside of Social Security can generally avoid taxes on their benefits. But those with additional income often get penalized in the form of taxes.

The taxation of benefits hinges on a calculation known as provisional income, which is a senior’s non-Social Security income plus half of his or her annual benefit.

Seniors face taxes on up to 50% of their benefits once their provisional income exceeds $25,000 for singles and $32,000 for married couples. They then face taxes on up to 85% of their benefits once their provisional income exceeds $34,000 and $44,000, respectively.

Gallery: 10 Roth IRA Mistakes That Could Cost You Thousands (The Motley Fool)

Are you using your Roth IRA to its fullest potential?

A Roth IRA can be an excellent retirement savings tool — if you know how to use it. Its investment flexibility and tax-free withdrawals in retirement make it an appealing choice to people of all backgrounds, but if you want to get the most out of your Roth IRA, you have to know the rules associated with it.

Failing to follow these principles can lead to some costly mistakes, like the 10 we’re about to talk about.

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1. Using a Roth IRA without considering the tax implications

A Roth IRA enables you to pay taxes now in order to avoid taxes on your retirement withdrawals. But that isn’t always a wise move. If you think you’re in a higher tax bracket right now than you’ll be in once you retire, you could face a hefty tax bill this year if you contribute to a Roth IRA.

It might be wiser to put your money in a traditional IRA. Contributions to these accounts give you a tax break this year, but you have to pay taxes on your withdrawals in retirement. If you expect to be in a lower tax bracket in retirement, this could be the wiser way to go. Or you could put some money in a traditional IRA and some in a Roth IRA.

ALSO READ: 3 Roth IRA Mistakes to Avoid This Year

2. Contributing when you’ve earned too little

In order to contribute to a Roth IRA or any retirement account, you must earn at least enough throughout the year to cover your contributions. For example, if you want to put $5,000 in a Roth IRA, you must have earned at least $5,000 during the year the contribution is for. If you contribute more than you earn, you’ll face a 6% penalty tax on the excess amount every year it remains in the account.

There is an exception for married couples. As long as one spouse has earned enough to cover contributions to both spouses’ retirement accounts, it doesn’t matter if the other spouse didn’t work at all. If a spouse contributes to an IRA on your behalf, it’s known as a spousal IRA.

3. Contributing more than the annual limit

In 2021, adults under 50 may contribute up to $6,000 to a Roth IRA. Adults 50 and older may contribute up to $7,000. These limits apply to your total contributions to all IRAs, not just Roth IRAs. But you can choose how to split this up. You might put $3,000 in a traditional IRA and $3,000 in a Roth IRA. Or you could put all $6,000 in a Roth IRA and none in a traditional IRA.

Exceeding the annual contribution limit will bring a 6% penalty tax on the excess contributions until you remove them. But just because you can’t contribute more than $6,000 now (or $7,000 if you’re over 50) doesn’t mean you won’t be able to do so in the future. The government reevaluates the contribution limits every year and periodically increases them to allow people to save more.

4. Contributing when you’ve earned too much

Individuals earning more than $125,000 and married couples earning more than $198,000 in 2021 are only allowed to make reduced contributions to their Roth IRAs. Single adults earning more than $140,000 and married couples earning more than $208,000 aren’t eligible to contribute to a Roth IRA directly at all. If you do so anyway, you’ll face a 6% penalty tax on the excess contributions.

There is a way to reap the rewards of a Roth IRA even if you can’t contribute to one directly. It’s called a backdoor Roth IRA. It involves contributing funds to a traditional IRA and doing a Roth IRA conversion in the same year. It requires a few extra steps, but it will get you to the same place in the end.

ALSO READ: The 3 Biggest Roth IRA Mistakes I Made in My 20s

5. Putting off contributions until the last minute

You have until the tax filing deadline to make Roth IRA contributions for the year. That means you can wait up until April 15, 2022, to make contributions for the 2021 tax year. While it’s better to make late contributions than none at all, doing so could cost you.

If you haven’t been diligently setting money aside for your retirement, you might reach the tax deadline and realize you don’t have anything left over to put toward your retirement. Even if you do, you’re missing out on several months of earnings you could’ve had if you’d invested that money sooner.

6. Forgetting to contribute any money

Failing to contribute any money toward your retirement this year is just going to make the task of saving enough that much more challenging. You’ll have to save more per year going forward to reach your goal because you won’t be able to count on investment earnings as much.

That said, there’s nothing wrong with choosing to contribute to other retirement accounts instead of your Roth IRA if you believe this makes more sense to you. Just make sure you’re putting some money aside every year for your retirement if you can.

7. Choosing the wrong investments

One of the great things about Roth IRAs compared with 401(k)s is that there are few limitations on what you can invest in. Most 401(k)s limit you to a few mutual funds your employer chooses, but Roth IRAs allow you to invest in stocks, bonds, mutual funds, exchange-traded funds, and more. You can also change your investments as often as you like.

But that doesn’t mean you’re immune to errors, like investing too much or too little in stocks or choosing costly investments. The wrong investments could expose you to too much risk or slow the growth of your investments. Spend some time to review your portfolio and investigate how much you’re paying in fees. Try to keep your annual fees below 1% of your assets if you can.

ALSO READ: This Is a Really Bad Reason to Open a Roth IRA

8. Withdrawing Roth IRA earnings too soon

You’re allowed to withdraw your Roth IRA contributions at any time without penalty, but you’ll pay a 10% early withdrawal penalty and/or taxes if you withdraw your earnings too soon. You must wait until you’re at least 59 1/2 and have had your Roth IRA for at least five years before you are free to withdraw your earnings without penalty.

There’s also a five-year rule for Roth IRA conversions. This says you can’t withdraw any converted funds from your Roth IRA until it’s been at least five years since you did the conversion. But the countdown begins on Jan. 1 of the year you did the conversion. So if you do a conversion right now, you could withdraw your funds penalty-free on Jan. 1, 2026, even though that’s only four-and-a-half years from now.

9. Forgetting about old Roth IRAs

If you open a new retirement account with a different broker, don’t forget to do something with your old Roth IRA. Leaving your retirement savings in multiple accounts can make it more difficult to manage, and you run the risk of forgetting about the account entirely.

Consider rolling your old Roth IRA funds over into a new Roth account so you can manage your money all in one place. A direct rollover, where you provide your old broker with details of where you want your money sent, is usually the safest option. If you choose an indirect rollover, where your old broker cuts you a check, you must remember to deposit the funds into your new account within 60 days to avoid owing taxes and penalties.

10. Only relying upon a Roth IRA

While a Roth IRA is a great addition to many people’s retirement plans, its low contribution limits mean it probably won’t suffice as your only retirement savings vehicle.

Consider adding a 401(k), 403(b), or self-employed retirement account to your retirement plan to enable you to save more money for your future. You can still put money in your Roth IRA first if you want. Then, once you’ve maxed that out for the year, you can switch to one of these other accounts.

How much will your Roth IRA be worth?

Avoiding the mistakes above is key to getting the most out of your Roth IRA. As long as you’re making regular contributions and staying mindful of the rules surrounding Roth IRAs, you shouldn’t have to worry about penalties and fees depriving you of your hard-earned cash.

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12/12 SLIDES

The problem, though, is that these thresholds have been in place for decades. In 1983, the decision was made to tax up to 50% of benefits at the aforementioned levels. In 1993, that rule was amended to tax up to 85% of benefits, also at those same levels.

Load Error

Meanwhile, the cost of living has risen substantially since then — yet the income thresholds for Social Security taxes haven’t. And that leaves seniors in a pretty bad spot.

Avoiding taxes on benefits

Seniors who save for retirement strategically may be able to avoid getting slammed with taxes on their Social Security benefits. And one of the easiest ways to make that happen is to save in a Roth IRA.

Roth IRA withdrawals are not taxable income and also don’t count toward provisional income. As such, a single tax filer who collects $18,000 a year in Social Security and also takes $24,000 a year in Roth IRA withdrawals would not have to pay taxes on benefits, despite having a total income of $42,000 and a provisional income of $33,000.

While higher earners aren’t allowed to contribute to a Roth IRA directly, there’s always the option to fund a traditional IRA and then convert it to a Roth account afterward. It’s a move worth making, considering that Roth IRAs offer other benefits in retirement outside of helping seniors avoid taxes on Social Security. For example, Roth IRAs are the only tax-advantaged retirement plan to not impose required minimum distributions.

It’s bad enough that seniors face taxes on their Social Security income. But what makes the problem worse is the fact that the income thresholds that determine that haven’t changed in multiple decades.

There’s already pressure on lawmakers to change the way Social Security raises are calculated. Senior advocates should consider encouraging lawmakers to revisit these tax rules, as well.