Here's a shocking statement: Some Social Security recipients are subject to the highest marginal income tax rates in the country — topping 55% in some cases — depending on their other sources of retirement income in a given year. What's even more shocking? It's true.
Most advisers think of income taxes in terms of the federal tax brackets: 10%, 15%, 25%, 28%, 33%, 35% and 39.6%.
But in the retirement space, taxes are different, particularly once clients turn 70½ and must start taking annual required distributions from their retirement accounts. Their effective marginal tax rate — the rate at which one additional dollar of income will be taxed when added to existing income — can be higher than the highest tax bracket.
Consider this example supplied by Social Security Timing, a software program for financial advisers to help their clients maximize their Social Security benefits: A married couple who is subject to required minimum distributions, has combined Social Security income of $50,000 per year, plus $15,000 in net long-term capital gains and $25,000 in IRA distributions.
Because of the higher standard deduction for the elderly plus two personal exemptions, the couple is in the 15% federal tax bracket, and will pay 0% on their long-term capital gains.
Then assume they need an additional $1,000 beyond their normal spending needs and decide to tap their IRA for the extra cash.
In their 15% federal tax bracket, you would expect that a $1,000 IRA withdrawal would cost them $150 in federal income taxes. You would be wrong.
That extra $1,000 IRA withdrawal will also drag 85% of an equivalent amount of Social Security benefits onto their tax return. The result: $850 of Social Security benefits will be taxed at 15%, adding another $127.50 to their tax bill ($1,000 x 0.85 = $850 x 0.15).
The combined ordinary income and additional Social Security income pushes the $1,850 of long-term capital gains into taxable status. That additional tax of $277.50 on their long-term capital gains brings the total tax on their $1,000 IRA withdrawal to $550 — a 55% effective marginal tax rate.
A wise adviser who could foresee future spikes in marginal tax rates may be able to create tax-saving opportunities, said David Cechanowicz, director of education for Social Security Timing. The sweet spot for planning is generally between the ages of 66 and 70 if your client has retired, is willing to delay claiming Social Security and is not yet subject to minimal withdrawal requirements from his or her retirement accounts.
“During that four-year period, you could either start doing Roth IRA conversions or harvesting IRA money,” Mr. Cechanowicz said. Taking a tax hit in one year can minimize taxes in subsequent years and reduce future RMDs.
“By delaying Social Security and changing the blend of income, I have seen 90% reductions in taxes,” he added. “It can be quite magical if you structure it well, particularly for middle-income clients.”
Of course, figuring out how to do that is a challenge. “The Bipartisan Budget Act of 2015 eliminated and is phasing out some Social Security claiming strategies that would have provided additional income to clients,” Mr. Cechanowicz said.
Social Security Timing is now offering a new “Tax Clarity” program that aims to help replace lost income by finding additional net household income. The company is offering a 10-day free trial of the program and a discounted annual fee through April 15.
Although Social Security Timing may be the latest software provider to look beyond the value of maximizing Social Security benefits to coordinate the overall tax efficiency of retirement income, it's not the only one.
A few months ago I wrote about Impact Technology's Cash Flow Decision program. It considers which claiming strategies will maximize Social Security benefits over a client's lifetime and also takes into account how clients' other income and assets could affect how much of their Social Security benefits are taxed.
Another Social Security claiming strategy pioneer William Meyer, founder of Social Security Solutions, and his research partner William Reichenstein, Powers professor of investment at Baylor University, first discussed the impact of this high marginal tax rate, which they dubbed the “tax torpedo,” and its effect on portfolio longevity several years ago. Last year, Social Security Solutions created a coordinated Social Security and tax-efficient retirement income drawdown program based on their research.
Figuring out how to help your clients keep more money in retirement is a great way to satisfy existing clients and attract new ones.
Mary Beth Franklin is a contributing editor to InvestmentNews and a certified financial planner.
The ninth paragraph of this story has been updated to indicate that the combined ordinary income and additional Social Security income will push long-term capital gains, not qualified dividends, into taxable status.