What you haven’t heard before about the taxation of Social Security benefits

[Midpack]

This was a very good read IMO, provided by daylatedollarshort, that I thought deserved a thread of it's own (we'll see).

Just a piece of the whole retirement income enchilada, but a worthwhile piece (that may be overlooked). I am still trying to get my head around optimizing taxes long term re: Roth conversion, excess RMD, managing capital gains, projecting dividends/STCG, taxable withdrawals, real returns, when to take Soc Sec (considering taxes), etc.

The attached 3-pg pdf excerpt is what some have called the (Soc Sec) "tax torpedo." The advantage for many of taking Soc Sec at age 70 may not be as simple as total projected benefit before taxes.

Here's the whole 18-pg paper FWIW http://research.prudential.com/documents/rp/InnovativeSocialSecurityNov2012.pdf

 

[Z3Dreamer]

Interesting scenario. The line at the bottom that says "Taxable Income" is really Adjusted Gross Income, line 37. I took those numbers subtracted Standard Deduction and Personal Exemptions, assumed a 7% state tax and came up with a rounded $10,300 in taxes for A and $2,600 for B or 11.5% effective rate on $90,000 for A and 2.9% for B. I have not yet read the 18 page document but I will. Thanks.

What does B do during the years between 62 and 70 (assuming both A and B are retired)? My guess is that B will just pull money out of deferred accounts. So B will have AGI of $90,000 and will pay $14,500 in federal and state taxes for 8 years, when A is paying $10,300. The breakeven point for taxes would be about age 77 assuming some minimal time value of money.
What about the effect on the balance in an IRA? Well, 8 years of B pulling out an extra $45,000 out of their IRA is $360,000. Then A begins pulling an extra $25,000. It takes until age 85 to equate assuming no earnings. Well into the 90's assuming some minimal earnings rate.
So depending on how long A and B live, the effects on their IRA balance may overshadow the tax effects in the scenario.

 

[Gumby]

The paper also assumes that the only source of income is either Social Security or taxable IRA withdrawals. A decent pension or two, or substantial earnings in a taxable account, could put you over the 85% SS taxation threshold no matter what you do.

 

[Midpack]

The paper also assumes that the only source of income is either Social Security or taxable IRA withdrawals. A decent pension or two, or substantial earnings in a taxable account, could put you over the 85% SS taxation threshold no matter what you do.

Agreed, though the paper is just trying to illustrate the "tax torpedo." I am in the midst of building a spreadsheet like the one in the OP, adding all sources of income (wages, dividends, STCG/LTCG, TIRA/Roth withdrawals, Soc Sec, etc.) and [-]calculating[/-] estimating FIT. A reasonable shorthand for a 1040.

 

[NW-Bound]

But, but, but how do we know if the tax codes won't get changed by the time we get to 70?

 

[Midpack]

But, but, but how do we know if the tax codes won't get changed by the time we get to 70?

I know you're joking, but they'll be input fields along with many other variables, so I can develop a sense of "sensitivities." While correct answers are impossible, learning how it all works improves my understanding/intuition and helps me maintain some spreadsheet skills besides. And I welcome projects in winter...

 

[Z3Dreamer]

A number of key times, I do a complex (obsessive per DW) computation and act on it. Then they change the tax code a few years down the road and it looks like I did the wrong thing. Kiddee tax is an example.

 

[Midpack]

A number of key times, I do a complex (obsessive per DW) computation and act on it. Then they change the tax code a few years down the road and it looks like I did the wrong thing. Kiddee tax is an example.

Understood, but I know there will be some surprises (wrong moves), still better than throwing up my hands and being oblivious IME. Time will tell...

 

[daylatedollarshort]

For us, I don't know if we will still have our businesses going (additional income as well as deductions) or even what continent, let alone country, we will be living in years into the future, so it is something we're not spending too much time on this year. Plus by then there may be changes to SS benefits or tax laws. Net worth smoothing-wise I would like to take SS at 62, but especially if we still have a business income at that age, that may not be a smart move income tax wise.

Right now we're working on a sweet spot MAGI that minimizes income taxes, leaves us enough money to pay the bills and maximizes ACA subsidies and college financial aid for 2014, and that is taking up all my brain CPU cycles.

 

[Alan]

Understood, but I know there will be some surprises (wrong moves), still better than throwing up my hands and being oblivious IME. Time will tell...

+1

I'm only 3 years away from making the decision on when to take SS and I think it will be better at that time to look at scenarios on current tax code rather than expect major changes to the tax code.

In planning ER I discounted SS, leaving it as "fat" in the budget. Once retired I put the full SS into the spreadsheets and planning software and am spending like we are going to get the full amount. If it gets cut then we cut back spending.

 

[MichaelB]

Understood, but I know there will be some surprises (wrong moves), still better than throwing up my hands and being oblivious IME. Time will tell...

If you collect and examine the facts, then make a reasoned decision, it will not be a wrong move, even if things turn out not as you expect. There are too many variables here to make the best choice, I think one should look to make a good choice and move on.

 

[Alan]

If you collect and examine the facts, then make a reasoned decision, it will not be a wrong move, even if things turn out not as you expect. There are too many variables here to make the best choice, I think one should look to make a good choice and move on.

+1

 

[Options]

...

What does B do during the years between 62 and 70 (assuming both A and B are retired)? My guess is that B will just pull money out of deferred accounts. So B will have AGI of $90,000 and will pay $14,500 in federal and state taxes for 8 years, when A is paying $10,300. The breakeven point for taxes would be about age 77 assuming some minimal time value of money.

What about the effect on the balance in an IRA? Well, 8 years of B pulling out an extra $45,000 out of their IRA is $360,000. Then A begins pulling an extra $25,000. It takes until age 85 to equate assuming no earnings. Well into the 90's assuming some minimal earnings rate. So depending on how long A and B live, the effects on their IRA balance may overshadow the tax effects in the scenario.

Something I'm grappling with as well. IMO, another variable impacting delaying SS until 70 while taking larger PF w/drawls from the PF (while also doing ROTH conversions) is the impact of market activity on the PF. Another 2008 scenario could lay waste to the best made plans. Guess I'm going to have remain flexible, agile, and responsive.

Understood, but I know there will be some surprises (wrong moves), still better than throwing up my hands and being oblivious IME. Time will tell...

Midpack, I appreciate your efforts on this as it is impacting my planning as well.

 

[NW-Bound]

I know you're joking, but they'll be input fields along with many other variables, so I can develop a sense of "sensitivities." While correct answers are impossible, learning how it all works improves my understanding/intuition and helps me maintain some spreadsheet skills besides. And I welcome projects in winter...

I still have a few years to even be able to claim SS early, which I may not. So, I do not think too much about tax issues now, other than doing some Roth conversion every year.

 

[clifp]

I knew about the 85% taxation treatment I didn't realize that only 50% of social security benefits were used to hit the 44K threshold. Still I expect to hit the 85% tax on Social Security no matter what I do.

The one thing that I think is become more clear is that for many people the optimum time to take heavy withdrawals from your non Roth IRAs is between the ages of 65 and 70. The withdrawal won't impact your ACA subsidies (since once you turn 65 you get Medicare). They also will have the lowest tax consequence since they wouldn't impact the tax treatment of your SS. This of course awesome that at least one person delays SS until age 70.

 

[Alan]

FYI, I have added this very interesting thread to the FAQ on when to take SS. It was a good idea for Midpack to add the pdf as an attachment in case, or when, Prudential remove the link from their website

http://www.early-retirement.org/forums/f47/faq-archive-when-to-take-ss-69366.html

 

[Katsmeow]

The one thing that I think is become more clear is that for many people the optimum time to take heavy withdrawals from your non Roth IRAs is between the ages of 65 and 70. The withdrawal won't impact your ACA subsidies (since once you turn 65 you get Medicare). They also will have the lowest tax consequence since they wouldn't impact the tax treatment of your SS. This of course awesome that at least one person delays SS until age 70.

Bear in mind that once on Medicare, withdrawals from IRAs can cause you to get to a point where your Medicare premiums go up.

With a joint income of $170,000 to $214,000 ($85,000 to $107,000 for individual) the part B premium goes up $42 a month. The Part D premium also goes up. At higher levels, the premium goes up more.

 

[Theduckguru]

Me thinks there are 2 issues concerning SSI in the future - taxes and means testing. In the absence of the political resolve to means test, you may see taxes used instead.

 

[Independent]

The Prudential piece says that deferring SS reduces my taxes after I start taking SS.
I don't see where it discusses the fact that deferring SS increases my taxes before I start taking SS.

My numbers look like this:

Start taking SS at 63 and 9 months,
for an annual benefit of $45,000. Also, take $45,000 from an IRA for a before tax income of $90,000.
In this case, about $26,000 of the SS benefit is taxable, and FIT may be $6,350, for an after FIT income of $83,250.


Now consider deferring to age 70.
In this case, in the years prior to age 70, I would take $93,500 annually from my IRA.
FIT would be about $10,250, for an after tax income of $83,250.

At age 70 and later, I would have a SS benefit of $70,000, and would only withdraw $13,600 from my IRA, for a before tax income of $83,600.
Only $9,900 of my SS would be taxable. FIT would be only $350, so my after FIT income would be $83,250.


So in the level case I withdraw $45,000 every year to maintain an after FIT income of $83,250.

In the deferred case, I withdraw $93,500 for the first 6+ years to maintain $83,500 of after FIT income.
But, then I only need to withdraw $13,600 for the rest of my life to maintain the same $83,500 of after FIT income.

So deferring SS means that I withdraw an extra $48,500 for the first 6+ years in order to reduce by withdrawals by $31,400 in the years after age 70.

This seems like a modest advantage for deferring, but not as dramatic as we would imagine if we ignored the before-SS period.

Of course, I'm ignoring the way inflation interacts with the non-indexed $32k and $44k. I'm also ignoring RMDs and any other sources of income.

 

[walkinwood]

Excellent paper especially the tax torpedo part. I bailed after a few pages on that topic though - I have 13 years before I have to really understand this subject.

 

[Brett_Cameron]

IMHO, there is nothing in the paper about how SS is taxed that is not in the IRS tax forms. The information is just put into words. Good paper, though, as an introduction to the tax calculations since the IRS form is cryptic.

 

[target2019]

I was impressed with the presentation. It puts your nose right into the complexity.

Towards the end of paper it reminded me of a FA presentation and of course there is an annuity to help you bridge the gap.

I really need to model all of the factors in a spreadsheet when I get the chance.

 

[Midpack]

Excellent paper especially the tax torpedo part. I bailed after a few pages on that topic though - I have 13 years before I have to really understand this subject.

I have 11 years. But if I wait and follow conventional wisdom, at 70 RMD's will force our income above our needs and our Soc Sec benefits will be very highly taxed. I'd hate to find I could have taken steps now to reduce net taxes overall and increase retirement income. I assume there are others in our situation, though certainly not all. FWIW...

 

[Independent]

I have 11 years. But if I wait and follow conventional wisdom, at 70 RMD's will force our income above our needs and our Soc Sec benefits will be very highly taxed. I'd hate to find I could have taken steps now to reduce net taxes overall and increase retirement income. I assume there are others in our situation, though certainly not all. FWIW...

I'm not sure what the "conventional wisdom" is here.

 

[Midpack]

I'm not sure what the "conventional wisdom" is here.

Understood. I meant the broader "conventional wisdom," not just here, things like:

• spend taxable first, then IRAs, then Roths
• take Soc Sec at 70 or as late as you can
• convert non-Roth IRAs to Roth IRAs if you believe tax rates will be higher later, don't convert if you expect (your) tax rates to be lower.

Not saying the "conventional wisdom" is categorically bad advice by any means (it's probably good in many cases), just that it's not necessarily as simple as that. They all have significant caveats...