By Danielle Howard
You worked hard to accumulate and plan for retirement. As you head into the fall (or distribution) season of life, do it with the same finesse. You need to discern which income streams to access, when to turn them on and how they will interact with each other. As you do this skillfully, you can create sustainable, tax-efficient income, keeping more in your pocket to address future uncertainties and shore up your financial legacy.
There are opportunities to avail and obstacles to overcome.
First, let's look at how Social Security benefits are taxed.
Your benefits are taxed at a preferred rate -- at least 15%, up to 100% is tax free. When your provisional income is less than $25,000 as a single person ($32,000 for married couples filing jointly) you pay no taxes on your benefit. When income is between $25,000 to $34,000 ($32,000 and $44,000 for married filing jointly), 50% of Social Security income is taxable. As your provisional income rises above those amounts, 85% of Social Security is taxable.
Provisional income is calculated by taking your modified adjusted gross income and adding half of the Social Security benefits received. This income includes IRA withdrawals, capital gains and brings back in non-taxable municipal bond interest.
Next, you want to keep taxation on your provisional income as low as possible, yet still have the cash flow you want or need. This entails planning early and refining annually.
A recent paper written by William Reichenstein, Ph.D, CFA and William Meyer, principles of Social Security Solutions Inc., and Retiree Inc., peels apart the implications of the "Tax Torpedo." This is the impact of marginal tax rates on increased income caused by taxation of Social Security benefits.
One of their key insights is "that provisional income includes all withdrawals for TDAs (tax-deferred accounts), but only half of Social Security benefits. Therefore, by delaying Social Security benefits, a household may be able to increase Social Security benefits by a given amount and decrease withdrawals from tax-deferred accounts by an equal amount. This substitution would cause provisional income to decrease, which could substantially decrease the taxable portion of Social Security and thus taxes."
Ultimately, you want to determine the strategies that will benefit your financial and life situation.
Traditional planning says push your tax-deferred accounts out as long as possible. Many people also succumb to the fear-based decision to take their Social Security benefit early. Stop. Consider a different strategy. Tap into your tax-deferred accounts earlier in retirement and delay taking Social Security until age 70. Your tax-deferred account will be smaller at age 70½ when you have to start taking required minimum distributions (RMDs).
In reality, research is showing that this strategy can actually extend your portfolio's longevity. By pushing Social Security out, you maximize your benefit, thus minimizing what you would need to take from your retirement accounts. Because you are not taking Social Security, you are not subject to the higher marginal tax rates caused by the tax torpedo.
Roth Conversion Opportunities
If you have a large IRA or other qualified retirement plan, you may want to consider converting part or all into a Roth IRA. Ideally, you want to do this prior to taking Social Security and before you turn 70½ when you are required to take RMD. You will have to pay taxes on the conversion, but if done strategically, can have a profound impact on the longevity of your investments portfolios.
You may get hit with higher Medicare premiums for a few years, (Medicare premiums are based on the latest available tax returns, generally two calendar years in arrears), but would lower them overall in the future. Once you have converted money over to your Roth, your distributions would be tax-free. You would have smaller RMD off of your IRA which holds the line on income taxes as well as the amount of Social Security benefits subject to Medicare premiums and taxes down the road.
You can't look at your retirement accounts, non-qualified investments, potential earned income opportunities, or Social Security options in a vacuum. Each person's situation is unique and no one solution works for everyone. You must look at your income strategy holistically incorporating every aspect of your personal and financial life. This is just one of the many complex facets you need to look at to optimize your income streams. It isn't about a "product," it is a process. You are at the helm. Put your crew together and steward the money passing through your life, with diligence, wisdom and care.
If you're within five years of retirement, find more encouragement with my Monetary Manifesto today.
About the author: Danielle Howard is a Certified Financial Planner, author, speaker and financial thought leader. She is author of Your Financial Revolution - Time to Recognize, Revitalize, and Release Your Financial Power. Advisory Services offered through Cambridge Investment Research Advisors, Inc., a registered investment adviser. Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Cambridge and WBD are not affiliated.