Conventional wisdom has held that it’s better to start Social Security benefits early and delay taking distributions from tax deferred accounts such as IRAs, the Thrift Savings Plan, and employer sponsored retirement plans for as long as possible. However, many retirees are unaware, or choose to ignore, the consequences this strategy will have on their after-tax, spendable income. By choosing to claim Social Security benefits early, retirees have elected smaller lifetime payments and will, therefore, have to take larger IRA withdrawals to meet their desired income needs.
From a tax perspective, this may not be the best choice, because Social Security income is not taxed the same as income from tax-deferred retirement plans. In fact, Social Security benefits are tax free until certain income thresholds are exceeded, and under current law, no more than 85 percent of Social Security benefits be subject to taxes. Compare this to tax-deferred retirement plan distributions where every dollar distributed is subject to income taxes right out of the gate.
Retirees have control of when and how to take distributions from their tax-deferred retirement plans and when to elect Social Security benefits. For many, consideration should be given to reversing conventional wisdom and instead take distributions from their retirement plan early in order to delay claiming Social Security. By doing so, their after-tax, spendable income can be increased.
To understand how this is possible, let’s take a look at how the Combined Income formula is used to determine how much of a retiree’s Social Security benefits are taxed. The formula starts by adding 50% of a retiree’s Social Security benefit to their other income, such as wages, pensions, investment income, and even non-taxable interest. The Combined Income is then compared to two thresholds to determine how much of a retiree’s Social Security benefit will be taxable.
The first threshold is $25,000 for single filers and $34,000 for joint filers – a Combined Income below these thresholds and Social Security benefits are completely tax free. However, once the Combined Income exceeds the first threshold, up to 50 percent of the Social Security benefits are subject to taxation. The second threshold is $32,000 for single filers and $44,000 for joint filer; up to 85 percent of Social Security benefits are subject to taxation when the combined income exceeds these thresholds.
Note that it is “up to” 50% and 85%; in reality, the formula is a 3 prong test that often results in a smaller percentage than the maximums when the respective thresholds are exceeded. The formula for calculating how much Social Security benefits will be taxable is the smallest of:
- 85% of the benefits; or
- 50% of the benefits plus 85% of any excess over the second threshold; or
- 50% of the excess over the first threshold, plus 35% of the excess over the second threshold.
Let’s take a look at how delaying Social Security can produce a higher after-tax income. To do so, we’ll compare the strategy of retiree A, who claims Social Security at 62, and Retiree B who claims at age 70. We’ll assume that both retirees are married, have a Social Security benefit of $2,000 per month payable at their full retirement age of 66, and both want a gross income of $60,000.
Since Retiree A claims his Social Security at age 62, his benefit will be reduced by 25 percent, which means he’ll receive $18,000 per year. In order to produce his desired $60,000 in income, he’ll have to pull $42,000 per year from his tax-deferred retirement account. On the other hand, Retiree B delays his Social Security to age 70, so his benefit will increase to $31,680 per year after receiving Delayed Retirement Credits of 8 percent per year from his age 66 to age 70. With the higher Social Security benefit, he’ll only have to pull out $28,320 from his IRA each year.
Applying the Combined Income formula we can calculate that $11,950 of Retire A’s Social Security will be subject to taxes, whereas only $6,136 of Retiree B’s Social Security will be subject to tax. When combined with their IRA income, Retiree A’s taxable income will be $53,950 ($42,000 + $11,950) and Retiree B’s taxable income will be $34,456 ($28,320 + $6,136) – a difference of $19,494. Assuming a Federal tax rate of 25 percent, this means Retiree B will pay $4,874 less in taxes each year.
Please note, this example ignores any potential Cost of Living Adjustments – including them would make delaying more attractive. Furthermore, the example doesn’t factor in that more than half of the states don’t tax Social Security benefits, so the tax savings could be even greater if you live in a state that doesn’t tax Social Security.
Sometimes it pays to think unconventionally.