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Did you know that up to 85% of your Social Security income could be subject to federal (and possibly state and local) income taxes? Many investors miss this important detail. “That can be a real shock when people begin collecting benefits,” says Ben Storey, director, Retirement Research & Insights, Bank of America.

How much of your Social Security income is subject to federal income tax depends on a variety of factors, including your federal income tax filing status and your modified adjusted gross income. But with a little upfront planning, you may reduce the possibility of taxes derailing your plans.

When your Social Security may be taxed

Social Security benefit taxes are based on what the Social Security Administration (SSA) refers to as your “combined” income. That consists of your adjusted gross income, plus any nontaxable interest you earned (and certain other items) and half of your Social Security income. The thresholds for when your benefits will be taxable vary based on your filing status:

Ways to lower your income over time

Because of these income thresholds, tax planning experts often advise looking for ways to lower your combined income. “When you plan for retirement,” says Vinay Navani, a shareholder with WilkinGuttenplan, an accounting and consulting firm in East Brunswick, New Jersey, “you need to think in terms of multiyear projections.” For example, if you anticipate a big one-time event, such as the sale of a business, you may be better off structuring the sale as an installment sale to be paid off over several years instead of an all-cash transaction. This can help evenly distribute your overall income and possibly keep you in a lower tax bracket, which could help reduce the portion of your Social Security benefits that is subject to federal income tax.

You may also want to consider a longer-term strategy for drawing from your individual retirement accounts (IRAs). That's because withdrawals from a traditional IRA generally will be included in your federal taxable income. Qualified withdrawals from a Roth IRA, however, are generally not included in your federal taxable income. So if you have both, you may want to carefully consider whether you should make withdrawals from your Roth IRA or traditional IRA first.

A word of caution if you are considering converting a traditional IRA to a Roth IRA: Any deductible contributions as well as earnings that you convert will be included in your federal ordinary income in the year of the conversion. That may be worth it, though, because of the Roth IRA’s other tax advantages. Another option is to sell a non-IRA investment that earns taxable income, such as a taxable bond portfolio, and purchase a tax-deferred account, such as a deferred annuity. You could structure the annuity to begin paying income in a few years, when you expect your federal taxable income, as well as your overall tax rate, to decline.

When earnings may reduce your benefits

Those hoping to work in retirement need to be especially careful if they’re planning to claim Social Security benefits early. Even if you’re just working part-time, it’s important to consider how that continuing income will affect your benefits.

The SSA caps how much you are allowed to earn if you start taking your benefits before full retirement age, which is between 66 and 67 for most baby boomers. For every $2 you earn over the limit, the SSA withholds $1 of your benefits. Once you reach the year that you'll turn your full retirement age, the earned income cap goes up, and for every $3 you go over, it’s a $1 withholding during the months until your birthday.

There is some good news, however: Because the penalty is determined by your individual earned income, if you retire early but your spouse doesn’t, your spouse’s earned income will not be factored into the earnings limit. Additionally, when you reach your full retirement age, the earnings limit disappears, and Social Security will recalculate your benefit amount if you were negatively impacted by the earnings limit.¹

Keep in mind, if you file your tax return jointly, your spouse’s earnings will be included when calculating your combined income for purposes of determining the taxation of your benefits.