Some retirees might understandably feel disappointed when the Social Security Administration (SSA) announces a lower cost-of-living adjustment (COLA), as it did this week.
As Kiplinger reported, the COLA for 2025 will be 2.5%, which could mean a smaller benefits check beginning in January for the approximately 68 million people receiving Social Security benefits. (The SSA also announced the 2025 Social Security tax limit, which has jumped 4.4%.)
In the past few years, the COLA has fallen from 8.7% to 3.2% and now to 2.5% due to cooling inflation. This leads to lower Social Security benefit payments, negatively impacting many retirees' financial well-being.
However, there is a potential upside that some retirees might overlook: tax benefits.
So, let's look at how a more modest Social Security COLA increase could potentially work in your favor when it comes to taxes.
Taxes on Social Security
Before we discuss the potential tax advantages of a lower cost of living increase, it's helpful to review how Social Security benefits are taxed.
- The amount of your benefits subject to tax depends on your "combined income." This calculation includes your adjusted gross income, nontaxable interest, and half your Social Security benefits.
- Up to 85% of Social Security benefits could be taxable if this number exceeds certain thresholds.
- Despite conceptions to the contrary, there is no specific age when your Social Security benefits are no longer taxed.
For more information, see Social Security and Your Taxes: Five Things to Know.
With all that in mind, you can see how a lower Social Security increase could lead to lower combined income. How can that help with your tax burden?
Low Social Security increase: Tax benefits
1. Staying Below Tax Thresholds. A smaller COLA increase can help keep your combined income below the thresholds where Social Security benefits become taxable. For some retirees, this could mean paying less in taxes or even avoiding taxes on their benefits altogether.
2. Avoiding the "tax torpedo.” You might not have heard of the "tax torpedo," but some use the term to describe a sharp increase in marginal tax rates for retirees with middle incomes. Essentially, as your income rises and more Social Security benefits become taxable, you could suddenly find yourself in a higher income tax bracket.
A more modest Social Security COLA can help some retirees avoid triggering this tax torpedo, lowering their effective tax rate.
3. Preserving other income-based benefits. Some retirees don't realize that a significant increase in Social Security benefits can affect other aspects of their financial lives.
A lower COLA might help you maintain eligibility for specific income-based programs or keep your Medicare premiums from increasing. (A small COLA can help limit how much Medicare Part B premiums can increase for many beneficiaries.)
4. More control over your tax situation. With a smaller increase in your Social Security income, you might be able to manage your overall tax picture with more flexibility.
For example, you might withdraw a bit more from your retirement accounts or realize capital gains in retirement without pushing yourself into a higher tax bracket.
Strategies to minimize retirement taxes
As always, however, retirees have to strategize to maximize retirement savings and minimize tax impacts. Some ways to do that involve reviewing your withdrawal strategy, ideally with different retirement “tax buckets,” and carefully managing required minimum distributions (RMDs).
You might also consider converting traditional IRA funds to a Roth IRA since you’ll likely be dealing with a lower benefit payment.
- You generally pay taxes (at ordinary rates) on the converted amount in the tax year of the conversion, but future withdrawals will be tax-free.
- This could potentially reduce your tax bill in years with higher COLAs.
Additionally, optimizing your charitable giving can help lower taxable income.
- For example, some retirees “bunch” donations in years with lower COLAs.
- This strategy consolidates donations for two years into one year, which could help you itemize deductions and offset the tax impact of other income sources.
Social Security benefits 2025: Bottom line
While these or other potential tax benefits can be significant, the key is to balance maximizing your benefits and minimizing your tax burden.
However, every retiree's situation is unique. What works for one might not be the best strategy for another.
- With reduced benefits, some retirees may struggle to cover basic living expenses
- This financial strain could lead to a lower standard of living
- Additionally, the effects of lower benefits can compound over time
That’s why it’s important to consult a qualified and trusted financial advisor or tax professional who can help you develop a personalized approach.
