Avoiding a retirement 'tax torpedo'

By Mary Beth Franklin

Apr 15, 2012 @ 12:01 am (Updated 11:18 am) EST

If your clients can wait, here is yet another reason why it can pay to delay claiming Social Security benefits: a smaller tax bite in later years.

Income in the early years of retirement that exceeds certain modest levels can trigger a “tax torpedo” that subjects up to 85% of Social Security benefits to taxation.

Delaying Social Security benefits, of course, means that many clients may have to rely more heavily on investment portfolios in the early years of retirement. But the result — in addition to the eventual tax savings — will be a substantially larger Social Security benefit, creating a larger base amount for future cost-of-living adjustments. And for married couples, a larger benefit for the main breadwinner means a bigger benefit for a surviving spouse.

“For retirees of modest means with average or above-average life expectancies, deferring Social Security benefits may provide their best hope of making their money last a lifetime,” said William Meyer, founder and chief executive of Retiree Inc.

A new study, “How the Social Security Claiming Decision Affects Portfolio Longevity,” — which Mr. Meyer co-authored with William Reichenstein, Powers Professor of Investments at Baylor University — found that the strongest portfolio longevity gains are associated with retirees with lower levels of financial wealth.

For them, Social Security represents a larger portion of their total retirement resources, so delaying those benefits has a strong effect on the portfolio's longevity.

If Social Security begins at 64 instead of 62, for example, a $200,000 portfolio will last four years longer, but only three years longer for a retiree with $250,000, according to the study. For retirees with $1 million or more, the additional portfolio longevity from delaying Social Security benefits until 64 is less than one year.

“This study provides information necessary for financial planners to help clients decide when to claim Social Security benefits,” Mr. Meyer said.

The full study, is available at retireeincome.com/research_april2012/jfp_ssportfoliolongevity.pdf.

By delaying Social Security benefits and receiving a larger monthly check, a retiree can reduce the amount of money he or she needs to withdraw from retirement accounts in later years to maintain the same level of spending. That can minimize the tax bite on Social Security benefits, further boosting spendable income.

TAX CONFUSION

Income taxes in retirement can be confusing. When a single retiree's adjusted gross income (plus half of Social Security benefits and any tax-exempt income) exceeds $25,000, up to half of his or her Social Security benefits are taxable.

When this so-called provisional income level tops $34,000, up to 85% of Social Security benefits — the maximum amount — are taxable. The threshold amounts for couples filing jointly are $32,000 and $44,000.

The amounts aren't indexed for inflation, meaning more Social Security benefits are taxed each year due to annual cost-of-living adjustments.

The “tax torpedo” refers to the hump — that is, the steep increase and then decrease — in the marginal tax rate as the rate rises to 50% and then tops out at 85%, even as income continues to increase. The study found that the impact of the tax torpedo is most dramatic for retirees in the $250,000-to-$600,000 wealth range.

To consider the implications of the tax torpedo, suppose Mary, a single retiree, has $35,000 in income plus her Social Security benefits.

She wants to withdraw funds to pay for an extra $750 of spending that year. Because Mary is in the 25% tax bracket, she assumes that she needs to withdraw $1,000 to create $750 of after-tax income.

But this $1,000 withdrawal would cause $850 more of her Social Security benefits to be taxed, increasing her taxable income by $1,850.

In short, Mary would pay $462.50 on the $1,000 withdrawal ($1,850 x 25%) from her 401(k), resulting in a 46.25% marginal tax rate. That is 85% higher than her usual 25% tax bracket.

If Mary had known she was in the income range affected by the tax torpedo, she might have withdrawn from her Roth IRA, which would be tax-free, or from a taxable account, which might trigger little or no taxes, rather than her retirement account to finance the additional spending.

“Advisers need to be careful to consider taxation on Social Security to ensure they don't bump their clients' taxes on benefits from 50% to 85%,” Mr. Meyer said. “If you control for taxes on Social Security, you can help your clients keep more money to fund their retirement.”

DELAYED CREDITS

For example, if a retiree is entitled to $2,000 in Social Security benefits at the full retirement age of 66, he or she will collect just $1,500 per month if he or she claims early at 62. But if the retiree waits until 70, when delayed retirement credits boost benefits by 8% for every year beyond full retirement age, the individual will collect $2,640 per month.

That amounts to $31,680 per year — money that one wouldn't need to withdraw from a retirement account to support the same level of spending and possibly avoid being hit by the tax torpedo.

Mary Beth Franklin (mbfranklin@investmentnews.com) welcomes your comments and suggestions for column topics. She will discuss strategies for claiming Social Security benefits at the InvestmentNews Retirement Income Summit in Chicago from April 30 to May 1.

  @IN Wire

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