On Retirement

Retirees can cut their taxes by delaying Social Security

Dec 16, 2012 @ 12:01 am

When individual retirement accounts and 401(k)s were created decades ago, the idea was to offer tax-deferred savings on retirement plan contributions while workers were most likely in their highest tax brackets and to tax distributions during retirement when, presumably, their income and tax rates had declined.

But just as millions of baby boomers prepare to retire, many worry about the possibility of higher taxes, whether or not the nation careens off the fiscal cliff.

“Instead of enjoying a lower marginal tax rate in retirement as most believe they will, the marginal tax rate on 401(k) and IRA withdrawals may be much higher for many retirees than the marginal tax rate they were paying on their earnings when they were working,” said James Mahaney, vice president of strategic initiatives for Prudential Financial Inc.

Although it may seem counterintuitive, convincing some clients to delay collecting Social Security benefits actually could reduce their taxes during retirement.

Mr. Mahaney explains it all in his newly updated research paper “Innovative Strategies to Help Maximize Social Security Benefits” (available at prudential.com).

Of course, not everyone can afford to postpone collecting Social Security, and because of poor health, some may not want to put it off. But for those who can, delaying benefits means that in addition to the eventual tax savings, they will receive a substantially larger month-ly benefit, which will create a larger base amount for future cost-of-living adjustments.

For married couples, a larger benefit for the main breadwinner means a bigger benefit for a surviving spouse.

Traditionally, it was thought best to delay withdrawals from tax-deferred retirement accounts as long as possible. But Mr. Mahaney's paper shows that it can make sense to tap retirement accounts to fund the initial years of retirement, allowing clients to delay collecting Social Security benefits until they are worth more.

The combination of smaller IRA withdrawals, which are fully taxed as ordinary income, and a larger portion of income from Social Security benefits, some of which would be tax-free, can result in a smaller tax bite in later years.

The “provisional income” formula, which determines how much of a retiree's Social Security benefits are subject to tax, can be very 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 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.

Calculating the taxation of benefits this way can create very high marginal rates on IRA withdrawals. Every additional dollar withdrawn often makes 85 cents of a Social Security dollar taxable. Thus a retiree in the 25% tax bracket could pay a 46.25% marginal tax rate on each additional dollar of income above that threshold ($1 of IRA income + $1 of Social Security income x 85% = 1.85 x 25% = 46.25%).

WHY DELAY PAYS OFF

By delaying Social Security benefits, many individuals will pay little or no taxes when a combination of higher benefits and smaller IRA withdrawals replaces the same level of retirement income. Remember that only half of Social Security income counts in the provisional-income formula, while all IRA income and even tax-free municipal bond income are included.

That means a married couple could have up to $64,000 of Social Security income — counted as only $32,000 in the provisional-income formula — before they would cross the first threshold that renders up to half of their benefits subject to taxes. That is higher than current maximum benefits for two people, but future benefits could easily reach that level.

Here is an example from Mr. Mahaney's study of how delaying Social Security benefits can pay off.

Assume that a retired couple claims Social Security early, collecting $45,000 in benefits and withdrawing $45,000 from their IRAs for a total income of $90,000.

Based on their provisional-income formula, they would have taxable income of $70,975.

Now look what happens if they rely on their savings initially and delay Social Security until 70. Assume that their combined Social Security benefits would grow to $70,000, so they would need just $20,000 in IRA withdrawals to create the same retirement income of $90,000. But because of the preferential inclusion of Social Security benefits, their taxable income will be just $35,350.

Many retirees could see a 75% drop in taxes paid when considering both federal and state taxes, the paper concludes.

mbfranklin@investmentnews.com Twitter: @mbfretirepro

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