In the complex field of social security retirement income maximization planning, a general rule of thumb is that you can increase your benefits by delaying the start of those benefits. From age 62 to 70, your benefit amount will increase by approximately 8% per year. In addition, any cost of living adjustments (COLA) applicable during that period will also increase your benefit amount.
In spite of these facts, approximately 40% of retirees elect to take their benefits at age 62 and nearly 70% take their benefits prior to full retirement age (which is 66 for current retirees). The reasons for filing early vary from the need to take money as early as possible, poor health, or the inability to continue to work.
In addition, the conventional thinking regarding retirement plan (eg. IRA’s and 401K’s) distributions is that one should delay withdrawals as long as possible in order to preserve and grow your retirement nest egg. As such, by filing for social security benefits early one could postpone withdrawals on retirement plans, at least until age 70 1/2 when required minimum distributions would commence.
However, this may not be the the optimal “draw down” strategy from a tax minimization perspective, as well as for many other reasons. In fact, in most cases, social security should probably be treated as the most prized retirement dollars that people should try to enhance. Unlike other retirement assets, social security offers a combination of inflation-fighting COLA, longevity protection, investment risk elimination, spousal and divorced spousal benefits, survivor benefits and children’s benefits.
From a tax minimization perspective, it may also be more beneficial to draw down on retirement assets first, allowing for increases in social security benefits. This strategy may appear to be counter-intuitive but, in many cases, social security payments may qualify for much lower effective income tax rates than income provided by liquidating traditional retirement accounts.
Although traditional retirement accounts allow for tax-deferred investment growth, all distributions are treated as ordinary income and taxed at the recipient’s highest marginal tax rate. Social security payments, by contrast, enjoy substantial exemptions from Federal income taxes.
To calculate the amount of your social security payments subject to tax, you must calculate your “Provisional Income”. The latter is the sum of your Adjusted Gross Income (AGI) + one-half of your social security benefits + tax-exempt income. If this combined income is less than $32,000 for a couple ($25,000 if single) then your social security payments are totally free of Federal income tax. Starting at these levels, 50% of social security benefits will be taxable, rising to a high of 85% for incomes above $34,000 (single) and $44,000 (joint filers). However, no more than 85% of social security benefits are subject to tax no matter how high your income is.
As such, albeit in an extreme example, if the only income a couple had was from social security then that couple would pay no income taxes on their combined social security income of up to $64,000! Although this is a highly unlikely scenario, it does demonstrate the advantageous tax treatment of social security benefits. Even the wealthiest tax payers should take note of the fact that the maximum amount of social security benefits that they are required to include in income is 85% versus 100% for ordinary income investments.
Since taxable retirement account income increases a person’s AGI, and thus may boost their tax rate on social security benefits, by spending down IRA balances early in order to defer taking social security, people are not only trading a dollar of high-tax retirement income for a dollar of lower-taxed social security, they are also reducing their future tax bite on social security benefits in the process.
Therefore, the conventional wisdom of taking income from your tax-deferred savings accounts as late as possible may not always be the best nor the most tax-efficient retirement income strategy when examined in combination with social security benefits. Since the latter offers significant tax benefits for most tax filers, the optimal retirement income strategy should take this into account.
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