Plan Now to Avoid Social Security COLA Tax Cliff in 2023

Rethinking their funding strategy can help clients mitigate the tax impact of a larger-than-average COLA.

The 2023 Social Security cost-of-living adjustment (COLA) is 8.7% — the largest COLA that has been seen for decades (by contrast, the 2022 COLA was 5.9%).

While the increase provides a powerful tool to help retirees cover rising prices caused by sky-high inflation levels, it can also create unanticipated headaches from a tax perspective. That’s because recipients’ annual incomes could increase to the point where they’re bumped into higher tax brackets — meaning that more of their overall Social Security benefits will be taxed.

Those taxpayers have options to mitigate the impact of a larger-than-average COLA and should take steps now to minimize their 2023 tax liability.

Understanding How Taxes Apply to Social Security Benefits

The Social Security COLA is determined based on the Consumer Price Index for all Urban Wage Earners and Clerical Workers (CPI-W). The COLA amount for 2023 is unsurprisingly high, given the rising cost of groceries, gasoline, housing and other basic necessities.

Not all Social Security benefits are taxed at the same rate. The level of taxation depends on the recipient’s “combined income” level. “Combined income” means (1) one-half of the taxpayer’s Social Security benefits, plus (2) all of other income, including tax-exempt interest.

That means wage and salary income, interest income, pension benefits and even withdrawals from traditional retirement accounts are counted in determining whether the taxpayer’s benefits are taxable.

If a taxpayer’s overall income is over $34,000 per year ($44,000 for married taxpayers who file joint returns), up to 85% of the taxpayer’s Social Security benefit may be taxed. Up to 50% of a taxpayer’s Social Security benefits may be subject to taxation if the individual’s combined income falls between $25,000 and $34,000 ($32,000 and $44,000 for joint filers).

Notably, these threshold income levels are not indexed for inflation — meaning that many more clients are taxed on their Social Security benefits.

The precise amount of Social Security benefits that are taxed is based on a formula and varies depending on the taxpayer’s specific income level (regardless of income level, Social Security beneficiaries never pay tax on more than 85% of their benefits).

Planning for 2023

While Social Security beneficiaries will see an increase in their Social Security checks starting in 2023, those increases may not be enough to keep up with rising costs. Because of that, many beneficiaries may decide to take larger withdrawals than are strictly required from 401(k)s, IRAs and other taxable retirement accounts.

That can push the taxpayer into an even higher tax bracket and cause a higher percentage of their Social Security benefits to be subject to taxation.

There are several strategies that can help minimize the tax impact while still allowing clients to access resources to cover rising costs. First, taxpayers should consider only taking their required minimum distributions (RMDs) from traditional retirement accounts to avoid penalties.

Those clients might instead consider making withdrawals from taxable brokerage accounts (where withdrawals are subject to lower long-term capital gains rates that range from 0% to 23.8%, when considering the added 3.8% net investment income tax). They might also consider tapping Roth accounts instead, since those funds are not subject to taxation again when withdrawn.

Tax-free withdrawals from health savings accounts (HSAs) can also be used to cover qualified medical expenses without impacting the client’s Social Security tax liability.

That said, it’s always advisable for the client to leave funds to grow tax-free within the Roth for as long as possible. To minimize their overall tax liability, most clients should consider taking withdrawals from multiple accounts based on their individual circumstances.

Conclusion

For most clients, the added tax liability generated by the 2023 Social Security benefit increase will not be substantial. On the other hand, no one wants to pay more taxes than necessary. With proper advice, many clients may find that they already have the tools at their disposal to minimize their overall tax liability for 2023.

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