Today I would like to discuss a misunderstood concept about how Social Security taxation actually works. Understanding this concept can help clients reduce or avoid Social Security taxes in certain situations while reducing federal taxes at the same time.
The basic issue is that IRA distributions have the ability to cause two tax formulas to kick in at the same time: the standard federal tax tables and the Social Security combined income formula.
A middle-income client that appears to be in the 12% federal bracket can actually be taxed much higher.
Let’s look at a situation with an unmarried retired client named Bob.
Bob’s sources of retirement income are $25,000 from Social Security and $30,000 from a Traditional IRA for a total of $55,000. Bob will owe approximately $3,150 in federal taxes for 2019 which seems fair. His effective tax rate is under 6%.
Let’s explore the planning opportunity in this situation. Bob’s last $7,000 of IRA distributions are creating both federal taxes at 12% and 85% of Social Security is becoming taxable.
Let’s look at this calculation:
$840 Federal Taxes @ 12% x $7,000
+$714 85% of Social Security taxable @ 12% x $7,000
$1,554 Total Federal Tax
This means that Bob is paying a 22.2% Effective Marginal Rate on that last $7,000 of distribution or about half of the total tax owed. We have some ways to work around this problem.
Here is the trick: if you can eliminate the last $7,000 of taxable distributions, then you can help your client avoid those taxes altogether.
If Bob had started planning earlier, we may have recommended that he:
- Start Contributing and Converting to a Roth IRA or Roth 401(k)
- Using a 4% withdrawal rate, we could have calculated Bob to need approximately 25 times his $7,000 ongoing need or $175,000 contributed or converted over time to a Roth IRA.
- This strategy would have to be dependent upon Bob’s highest tax bracket during his working years.
- Contribute to a Non-Qualified Account
- This is similar to the Roth, but we also have to factor in the additional tax of capital gains.
- Delay taking Social Security and live on Traditional IRA distributions for a period of time
- By delaying Social Security, Bob would receive more Social Security dollars later and need lower distributions from his IRA. This would also lower his overall federal taxes in the future.
Unfortunately for Bob, he may not have many choices since he only has the Traditional IRA and has already begun taking Social Security. This is just another reason why the planning process should begin at least five to ten years before retirement to get the best results for the client.
Stay tuned for more blog posts and other great Tax Savvy Content.
Corey is SSN’s in-house consultant on tax planning. He shows advisors how to dig into complex strategies and consider the implications of taxes as clients are getting ready to retire.