Trim the tax on Social Security benefits in retirement ? Business ...

It?s bad enough that you have to pay Social Security taxes while you?re working, but you could also get hit with federal income tax on Social Security benefits received in retirement!

Strategy: Figure out if you?ll be taxed on Social Security benefits. If so, make moves to reduce your tax liability.

Here?s the whole story: Whether or not you must pay tax on Social Security benefits depends on the amount of your ?provisional income? (PI). For this purpose, PI is the total of your AGI, tax-exempt interest income and one-half of the Social Security benefits received.

For example, if your AGI is $80,000 and you collect $12,000 in municipal bond income and $16,000 in Social Security benefits, your PI for the year is $100,000 ($80,000 + $12,000 + $8,000).

There are two tiers for taxing Social Security benefits. Here?s how it works:

Tier 1: If your PI is between $32,000 and $44,000 ($25,000 and $34,000 for single filers), you must pay tax on the lesser of one-half of your benefits or 50% of the amount by which PI exceeds $32,000 ($25,000 for single filers).

Tier 2: If your PI is above $44,000 ($34,000 for single filers), you must include in taxable income 85% of the amount by which PI exceeds $44,000 ($34,000 for single filers) plus the lesser of the amount determined under the first tier or $6,000 ($4,500 for single filers). Caveat: In no event can the taxable amount exceed 85% of the benefits received.

4 ways to reduce your tax bill

The trick for reducing the tax is to knock down your PI below one or both of the tier thresholds. Here are four ideas:

1. Cash in on stock market losers. Capital losses triggered before the end of the year can offset capital gains plus up to $3,000 of ordinary income. This may be enough to pull down your PI to a lower-taxed level.

2. Cash in bank CDs to pay for living expenses. The CDs produce income that will increase your PI. At the same time, hold onto stock with long-term growth objectives.

3. Defer taxable income to next year. For example, if you plan on investing in CDs or T-Bills, make sure you acquire investments that won?t mature until 2013 or later.

4. Double up on IRA liquidations. If you have to tap your IRA for living expenses, take a double distribution in 2012. If you aren?t required to take withdrawals in 2013, you could live off of the proceeds without taking taxable funds from your IRA.

Tip: This last strategy could result in tax in alternate years.

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