There are really only three ways to reduce your provisional income. We learned in our last article that provisional income is a measure used by the IRS to determine whether or not recipients of Social Security are required to pay taxes on their benefits. Provisional income is calculated by adding up a recipient’s gross income, tax-free interest, and 50% of their Social Security benefits.
So, the three main ways to reduct your provisional income that will not impact your Social Security benefits are a Roth IRA, Life insurance and a HECM. Let’s examine these in more detail.
A Roth IRA allows for income to be withdrawn after the age of 59.5 tax-free if the funds have been in there for more than 5 years. The problem historically with Roth IRA’s has been that you can only contribute $5,000 per year prior to turning 50 and $6,500 for those 50 and older. Some 401K plans have a Roth IRA provision that allows higher contributions but those have only become more common in the last 10-15 years. So, building up a significant Roth IRA balance, where you could take income at a meaningful amount to offset provisional income while still maintaining your standard of living, may be difficult.
Life Insurance allows for cash-value build up and is an important asset if designed correctly for cash-accumulation. The beauty of life insurance is that there is no limit to how much you can put in, within reason, and no restriction on income prior to 59.5. It is a flexible instrument and cash-values accessed either within your cost-basis or via loans are non-taxable and not factored into your provisional income calculation. With no limit on contribution size, more meaningful amounts can be amassed faster.
HECM or a Home Equity Conversion Mortgage is one of the neatest instruments and probably most misunderstood. We are going to wrap up our series on provisional income and start a series solely focused on the HECM because it will become more mainstream as more understand it’s power and flexibility. A HECM allows a home owner to eliminate their mortgage payment if they are older than 62, if they reside in their primary residence and if they qualify for the financing even if they do not have their house paid-off. If you are retired and claiming Social Security, you will need to take funds from your IRA or other sources to cover your mortgage payment and that is also counting towards your provisional income calculation. If that mortgage payment went away, you would not need to withdraw those funds to pay that bill.
Further, if you have a positive Home Equity Line of Credit attached to your HECM, which we would recommend, you could access home equity to live off of to reduce your taxable income thus adding to your provisional income calculation without triggering a payment on your mortgage.
Utilizing these three instruments in retirement in concert with Social Security could potentially defray taxable income thus raising your provisional income and tax liability.
If you would like to see if these three instruments could adjust your tax liability, please contact us here.