Would you like to earn money while sipping coffee on your porch, spending time with your grandchildren, or even sleeping? That’s the freedom and flexibility that passive income offers.
More Americans have been pursuing side hustles and leveraging the power of the internet to create passive income streams. According to the US Census Bureau, around 20% of American households earn about $4,200 in passive income a year.
While the allure of earning income in your sleep is undeniable, it’s important to consider the potential impact on Social Security retirement benefits. Specifically, does passive income affect Social Security benefits? Here are the key details to know and steps you can take to mitigate the potential impact, ensuring a more secure retirement.
What Is Passive Income?
While earned income stems from something you do, such as working or operating a business, passive income is the opposite. It’s cash flow generated from assets. Examples of passive income include:
- Interest income from a high-yield savings account
- Income from individual retirement account (IRA) distributions
- Annuity payments
- Royalty payments for intellectual property
- Revenue from rental property
- Bond income
- Dividend payments from investments
- Payments from real estate investment trusts
- Revenue from affiliate marketing
Does Passive Income Affect Social Security Benefits?
Passive income generally doesn’t reduce your Social Security directly, but it can cause more of the benefit to be taxed, reducing your net receipt. Here’s why: You must report and pay federal taxes on passive income, which may cause your combined income to exceed the annual threshold.
Your combined income is the total of:
- Your adjusted gross income (AGI) from your tax return, which includes wages, self-employment income, pension benefits, dividends, interest, or any other form of taxable income.
- Any interest income that isn’t taxed at the federal level, such as municipal bond interest.
- One-half of your Social Security income.
If your combined income exceeds the base amount for your filing status, your Social Security income is likely taxable. Here are some related considerations:
- Your Social Security benefits aren’t subject to income tax if your combined income in 2024 is less than $25,000 for individuals ($32,000 for married couples filing jointly).
- Up to 50% of your benefits are taxable as ordinary income if your combined income falls between $25,000 and $34,000 ($32,000 and $44,000 for joint filers).
- Up to 85% of your Social Security benefits could be taxed if your combined income exceeds the limits.
Additionally, if you live in one of the eight states that tax Social Security, your liability may be even higher.
How Age Factors into Benefit Calculations
If you’ve reached your full retirement age (FRA)—the age when you qualify for 100% of the maximum benefit based on your lifetime earnings—you can work and earn as much as you like without directly reducing your Social Security benefit amount. On the other hand, working and earning income before reaching your FRA may temporarily reduce your Social Security. Once you reach your FRA, the Social Security Administration (SSA) adjusts your benefits upward to account for the reduction during your working years.
No matter your age, passive income doesn’t directly reduce your Social Security. Even so, it can negatively impact your benefits through tax implications.
What to Know About Lifetime Earnings Calculations
Your lifetime earnings are crucial in determining your Social Security benefits amount, but passive income isn’t included in lifetime income calculations. Your lifetime earnings help determine your average indexed monthly earnings (AIME), an inflation-adjusted average of your highest 35 years of earnings.
AIME is the basis for your Social Security benefits. The IRS includes wages and self-employment earnings in your lifetime earnings calculations because you pay Social Security taxes (FICA) on them. However, you don’t pay FICA on passive income, so this money is left out of lifetime income calculations.
Strategies to Maximize Social Security Benefits and Passive Income
The SSA estimates that about 40% of people who get Social Security must pay federal income taxes on their benefits. However, this number could be significantly lower with strategic long-term planning. Working with an experienced financial professional can help you devise a strategy that aligns with your goals, giving you a more tax-efficient retirement.
You can use the following strategies to maximize Social Security and minimize taxes.
Delay Claiming Social Security Benefits
Waiting until your FRA to take Social Security can increase your benefit amount. Every year you delay beyond your FRA, you can increase benefits by around 8% annually, maximizing lifetime benefits and reducing the years your benefits are taxed. This strategy can also keep your taxable income lower in the earlier years of retirement and minimize the impact of Social Security in later years.
Plan Early to Manage Your Taxable Income
Withdrawing funds from traditional IRAs, 401(k)s, and other tax-deferred sources before receiving Social Security can help reduce your combined income and minimize taxes.
For example, if you plan on receiving Social Security benefits in five years, withdrawing funds from your traditional IRA and 401(k) can help maximize your taxable income before you start receiving benefits. In turn, this can potentially minimize your AGI after receiving Social Security.
Use Roth IRAs for Tax-Free Income That Isn’t Included in AGI
Once you start receiving Social Security, any nonexempt interest and taxable income from a 401(k) or traditional IRA count toward your combined annual income. This passive income could cause you to pay extra taxes on your Social Security benefits. However, Roth IRA distributions don’t increase your AGI and don’t trigger taxes on your Social Security benefits.
Use Qualified Charitable Donations While Reducing AGI
Another strategy is to leverage qualified charitable distributions (QCDs) to reduce your AGI and lower the likelihood of Social Security taxation. Specifically, if you’re over 70½, you may be eligible to donate $100,000 from your IRA to a charity without it counting as taxable income. This charitable act not only supports causes close to your heart but helps shield your Social Security benefits from higher taxation.
Work with an Experienced Financial Professional
Navigating the complexities of Social Security and passive income doesn’t have to be overwhelming. With proactive planning and the right strategies, you can enjoy the financial rewards of your passive income without jeopardizing your benefits. Whether you’re in the early stages of retirement planning or need advice on optimizing your current strategy, working with a financial professional can help you feel more prepared and confident about your future.
Mitigating the Impact of Passive Income on Benefits and Taxes
At Bankers Life, we understand your retirement is about more than the numbers—it’s about helping make your vision of the future a reality. Our trusted team members can assist you in creating a comprehensive, personalized plan, so you can spend more time enjoying your golden years while your hard-earned dollars do the heavy lifting.
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