We received a couple of questions on our recent post “How to Increase Retirement Wealth With the Right Withdrawal Order” and will address the first one here. (Note: as we mentioned earlier this year, we will be making an effort to address more reader questions on the blog this year, so, if you have questions send them in.)
The question has to do with the issue of taxes. Specifically, is taking IRA distributions before you are required smart given a potential increase in taxes paid on Social Security income or is it better to delay Social Security in the first place. Here’s the question:
What about the effect of taxable income on SS taxes? Or delay SS with additional withdraws from retirement accounts to cover delay in SS?
This question breaks down into a couple of parts: First, how social security income is taxed and second when to start taking it.
How Social Security is Taxed
As identified in the study “Tax-Efficient Retirement Withdrawal Planning Using a Comprehensive Tax Model,” the best two withdrawal order strategies fill up the income bucket to either the level of deductions or the 10% marginal tax rate bracket. To optimize the level of withdrawals from your tax-deferred accounts (IRA, 401(k), etc.), and therefore your taxable income, you must factor in income from all sources including social security, earned income, etc.
So, when is social security income taxed? Right now, across all beneficiaries about 70% of social security income is tax-free. However, if your “provisional income” is between $32,000 and $44,000 for a joint return (or $25,000 to $34,000 on a single return) up to 50% of your benefit can be taxed—the remainder is tax-free. Should your “provisional income” exceed $44,000 (or $34,000 for single filers), up to 85% of your benefit can be taxed. And just so it’s clear, the tax is not 50% of the benefit but simply that 50% of the benefit is treated as taxable income and subject to tax. (Here’s the full IRS worksheet for anyone interested and a helpful online calculator can be found here.)
An example should clarify how this works. Suppose you are married and file jointly. In a given calendar year you have IRA distributions of $15,000, earned income of $15,000, and $24,000 in social security benefits resulting in total “provisional income” of $42,000. Because your “provisional income” is between $32,000 and $44,000, 50% of your social security income is subject to taxation. In this case, $5,000 of the social security benefit is added to taxable income (50% of the difference between total provisional income of $42,000 and $32,000) resulting in $35,000 of total taxable income. This taxable income is then offset by your deductions and personal exemptions.
Assuming we are taking the standard deduction of $12,600 (married filing jointly for 2016) and two exemptions ($4,050 each) gives of total deductions of $20,700. So, you’re left with $14,300 of taxable income ($35,000 - $20,700) which is taxed at the 10% marginal tax rate. But for those filing as married (joint), they can go up to $18,550 of income and still remain at the 10% tax rate. Therefore, an opportunity exists to take an additional $4,250 of income, in the form of withdrawals from your tax-deferred accounts, and remain at the 10% marginal tax rate.
Of course, if you didn’t yet have “provisional income” greater than $32,000 (or $25,000 for those filing a single return) your social security benefit would be completely tax-free and there would potentially exist an even greater opportunity to optimize your IRA distributions. You could take up to $20,700 if you had no other income and pay zero in taxes (because it’s offset by your standard deduction and personal exemptions) or take a $39,250 of withdrawals of which the first $20,700 is offset by deductions and the next $18,550 is taxed at the 10% rate—for an effective rate of 4.7%. Not too bad.
Should you delay your Social Security Benefits
Now the second part of this question is about delaying social security. As the question alluded to, it is almost always beneficial to defer taking your social security benefits. In addition to giving you an opportunity to maximize the benefits of withdrawal order strategies before you start taking social security, the government also gives you a “risk-free” return on your Social Security benefits should you defer.
A retiree starting social security at age 66 (the current full retirement age) might get $1,000 per month. According to the Social Security Administration, for anyone born after 1943 this would increase by 32% to $1,320 if deferred to age 70 but fall to $750 if taking it as early as possible—age 62.
The typical reason people want to take their benefit sooner is concerns about health: either theirs or the government itself.
You can read more of our thoughts on the health of the social security plan here, but it's generally thought that the benefits will be protected for those retired or nearing retirement age.
Now, regarding you own health, what many people don’t realize is that the breakeven age to delaying benefits is fairly young. Assuming you elect to defer until 70, you only need to live to 80 to collect as much in benefits as if you start taking them at the earliest possible age. According to the Social Security Administration’s actuarial table, a 62-year-old male has a life expectancy of twenty years, meaning you only need to survive for less than half of this period to come out ahead—again, a pretty good bet.
But, what’s more, a helpful question to ask is: what’s the worst thing that could happen? Financially speaking (and I’ll acknowledge this is a bit morbid) it’s not dying young, but instead, living a long time and outliving your income. Delaying social security and increasing the benefit amount is a powerful form of longevity insurance. As financial author and neurologist William Bernstein has said, "What is worse, dying at age 69 and never getting Social Security? Or, living from 82 to 92 on cat food?"
So, to wrap up, the majority of social security benefits are not taxed, but even if yours are there may still exist opportunities to pursue withdrawal order strategies that minimize taxes and increase wealth over your retirement. And delaying social security benefits gives you more time and space to optimize the withdrawal strategies while also serving as a powerful form or longevity insurance.
At Cordant, we help Intel and other corporate employees develop retirement income and withdrawal strategies that align with their objectives in addition to tailoring a financial plan and investment portfolio to meet their goals. If we can help in any way, please get in touch here: http://info.cordantwealth.com/request-a-meeting
 “Provisional income” is calculated as your adjusted gross income (not including Social Security) plus 50% of your benefits Social Security plus any tax-free interest from municipal bonds.
Cordant is not an accounting firm and does not provide tax or legal advice. The information provided herein is intended to assist you with the administrative aspects of planning for your tax requirements. Your personal circumstances should be reviewed with your tax advisor.