Have $2 Million Saved? Social Security Could Face a Bigger Tax Bill Than You Think

Building a $2 million retirement nest egg can take decades of saving, investing, and steady income. But where that money sits can have an unexpected effect on how much of your Social Security benefit gets taxed.

As much as 85% of your Social Security benefits can be subject to taxes. Understanding how that works is an important part of building a retirement plan.

Why large balances can trigger the maximum

The IRS uses your combined income — adjusted gross income plus nontaxable interest plus half of your Social Security benefit — to decide how much of your benefit is taxable. If that total goes above $34,000 for a single filer or $44,000 for a married couple filing jointly, up to 85% of the benefit may be taxed.

If most of your retirement savings are in a traditional retirement account, withdrawals are generally treated as ordinary income.

The required minimum distribution challenge

A larger Social Security check can lower the amount you need to pull from savings for daily expenses, but required minimum distributions, or RMDs, can still push you into a higher tax bracket. People born between 1951 and 1959 must begin RMDs at age 73, while those born in 1960 or later start at 75.

In the first year, an RMD can require a withdrawal of about $75,000 from a $2 million IRA. Once you reach the applicable age, the IRS requires minimum withdrawals whether you need the cash or not.

That kind of distribution can do more than make up to 85% of your Social Security taxable. It can also increase your overall tax bill by moving you into a higher bracket, which often catches retirees off guard.

How Medicare costs can rise too

The same RMD income can also affect Medicare premiums. Part B and Part D costs are based on income, and premiums rise once single filers cross $109,000 in modified adjusted gross income. For married couples filing jointly, the threshold is $218,000.

The taxable portion of Social Security counts toward modified adjusted gross income.

Ways to help reduce the tax hit

Taking steps before RMDs begin can reduce the impact, help preserve more of your benefits, and limit Medicare premium increases. One option is to make partial Roth conversions each year in your 60s, which can shrink your tax-deferred balance while building a pool of tax-free money for later.

Qualified charitable distributions may also help once you are 70 1/2. At that point, you can direct up to $111,000 a year from a traditional IRA to charity.

Planning ahead is better than waiting until the first RMD arrives. Managing withdrawals and using other strategies during your 60s can spread out the tax burden instead of leaving you with a larger bill later in retirement.