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

[walkinwood]

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...

Absolutely agree. I understand the broad concepts in the paper & am taking steps to reduce RMDs. My comment was directed towards the minutiae.

 

[Free To Canoe]

Good paper! I have read what seems like dozens of threads on SS on this forum and did reading on the SSA website and other places. Most but not all of what is in the paper I have heard at one time or another. Couldn't call them all up when needed if my life depended upon it. IMHO this paper does a better job of summarizing the SS landscape than the SSA booklets or any other single document. Thanks!

 

[ziggy29]

In any event, the lack of indexing on the thresholds subject to triggering the 50% and 85% taxability of Social Security has been a stealth tax hike and "means testing" of the program for 30 years. The larger your payments, the more likely you may be to kick yourself into a "higher bracket" where the taxation of your benefits are concerned. At least in "boundary line" cases, these are things to keep in mind. You may not want to wait another couple years to collect if the higher payments are likely to make your benefit 85% taxable instead of 50% taxable.

 

[Z3Dreamer]

Ziggy, you hit the magic button that asks for my opinion on the taxability of SS. I feel that the money that I will receive is after tax money I put into the system. At least half of it. So taxing SS at 85% at any time is so wrong. And based on some rough numbers, if I manage to stay at 50% taxed and begin collecting at 62, it will take me until age 84 to recoup my investment. I apologize for getting slightly off subject, but...

 

[Midpack]

In any event, the lack of indexing on the thresholds subject to triggering the 50% and 85% taxability of Social Security has been a stealth tax hike and "means testing" of the program for 30 years. The larger your payments, the more likely you may be to kick yourself into a "higher bracket" where the taxation of your benefits are concerned. At least in "boundary line" cases, these are things to keep in mind. You may not want to wait another couple years to collect if the higher payments are likely to make your benefit 85% taxable instead of 50% taxable.

That had occurred to me too. If I'm reading correctly, the 50% of Soc Sec added to income was enacted in 1984, and the additional 85% threshold in 1993. I was oblivious then due to my age then, and it's only dawning on me more recently, but it appears Soc Sec means testing was largely implemented quite some time ago...

 

[pb4uski]

....I'm also ignoring RMDs and any other sources of income.

And I think that could be the rub. A large part of the benefit of deferring SS and drawing from tax-deferred (and/or Roth conversions at 15% or lower marginal tax rates) from ER until age 70 is to reduce RMDs from 70 onwards. Those RMDs, along with SS can easily push you into the 25% tax bracket.

 

[Lsbcal]

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 don't know about other situations but in our situation I think I had 2 choices:
1) Take early SS and live with the SS + IRA taxes at RMD time
2) Defer SS and live with the SS + IRA taxes at RMD time

In situation (1) the IRA RMD's would be somewhat reduced by the fact that I partly depleted the IRA by deferring SS. But in (1) the SS went up so it partly reduces that benefit. In both cases my IRA RMD's would be substantial so the SS was never going to get good tax treatment, i.e. the SS would be taxed up to 85% in either scenario I think.

Perhaps I am misunderstanding something here.

 

[Lsbcal]

And I think that could be the rub. A large part of the benefit of deferring SS and drawing from tax-deferred (and/or Roth conversions at 15% or lower marginal tax rates) from ER until age 70 is to reduce RMDs from 70 onwards. Those RMDs, along with SS can easily push you into the 25% tax bracket.

How do you know the IRA's would be reduced enough? Doesn't it depend also on forward investment performance as well as spending/conversions?

Seems it's very dependent on the size of the IRA at the RMD stage.

 

[Running_Man]

Is the tax really all that severe? Lets assume at age 70 single male will need to RMD 4% of a million dollar portfolio. Also start taking SS at 3K per month or 36K per year giving a 76K annual income. At 40K of income and 36K of social security for a single person the additional taxable income would be:

Test 1: 85% of 36,000 = $30,600

Test 2: 1/2 SS Benefits : $18,000
Combined Income $58,000
Less second threshold $34,000
Excess above 2nd threshold: $24,000
85% of excess: $20,400
TOTAL TEST 2 $38,400

Test 3
Provisional Income $58,000
Less 1st threshold 25,000
Excess above 1st threshold 33,000
50% of excess above 1st thresh 1 6,500
35% of excess above 2nd thresh 8,400
Total Test 3 $24,900 equal 69 percent of SS

Taxable income would be $64,900 less standard deduction of $6,500 and personal exemption of $3,950 leaves taxable income of $54,450 and a tax for a single of $9,468.75 or 12.5% of total income based on 2014 rates. This is 23.67 percent of the total 401K withdrawl so to take an early 25% tax for a single to convert to an Roth IRA would make very little sense in this case, and if you are making a lot more than this I think you should be patting yourself on your back for being better than 90% of all other retirees.

An excellent article I loved it

 

[pb4uski]

How do you know the IRA's would be reduced enough? Doesn't it depend also on forward investment performance as well as spending/conversions?

Seems it's very dependent on the size of the IRA at the RMD stage.

Yes, it is dependent on investment performance, but in my model I keep investment performance the same. I assume that from now to 70 I do either LTCG or Roth conversions to the top of the 15% tax bracket. I have separate assumptions for investment results and inflation that are the same as in my retirement planning model.

If I prioritize LTCG my projections are that my SS and RMDs will push me into the 25% tax bracket for about 7 years beginning at age 70. If I prioritize Roth conversions then I avoid the 25% tax bracket entirely.

If investment performance is better than assumed then it may push me into the 25% bracket even if I do Roth conversions, but not as deeply nor for as long as if I prioritize LTCG. YMMV and it may be due to my circumstances.

 

[Running_Man]

Yes, it is dependent on investment performance, but in my model I keep investment performance the same. I assume that from now to 70 I do either LTCG or Roth conversions to the top of the 15% tax bracket. I have separate assumptions for investment results and inflation that are the same as in my retirement planning model.

If I prioritize LTCG my projections are that my SS and RMDs will push me into the 25% tax bracket for about 7 years beginning at age 70. If I prioritize Roth conversions then I avoid the 25% tax bracket entirely.

If investment performance is better than assumed then it may push me into the 25% bracket even if I do Roth conversions, but not as deeply nor for as long as if I prioritize LTCG. YMMV and it may be due to my circumstances.

I must admit I do not understand the logic, here is why, what do I have wrong?

If one where to convert to a Roth @ 30K per year for 10 years between age 60-70 you will subtract 300K from the portfolio and lowered the required RMD. However at age 70 only about 4% of that would be subject to withdrawl or 12K on the 300K you reduced and a tax of 25% that is $3,000.

However you would have paid tax at 15% total or $45,000 and permanently lost the earnings on that amount. Just in the 10 years this would have been implemented you would forgo earnings of $14,081 at a 5 percent return and $28,987 at a 7 percent return. Along with the 45K of tax paid this is 20 years to make this back up, excluding the effect future earnings foregone on the already taxed portion past age 70 . What am I seeing wrong?

 

[Options]

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.

That's exactly the problem, I believe. The interaction of delaying SS and RMD's (and any other income sources) impacts tax planning, not to mention how inflation interacts with the non-indexed $32k and $44k. Those of us considering ROTH conversions before 65 also have to watch out for income over $85K in the two years before Medicare, as that will result in indefinite higher Medicare premiums. [Edit: Before 65, there's the impact on ACA subsidies when considering ROTHS as well.]

I personally don't trust any spreadsheet I could come up with as I'm just not that smart . My plan (for now) is to do ROTH conversions just up to the 15% tax bracket until age 70. ORP calculator shows I'll be in this bracket indefinitely. Do I trust it? Not exactly. But between these conversions and the fact that 2/3 of my PF is in after-tax/some ROTH currently, it's about the best I can do, particularly since I don't want to over think it.

 

[Midpack]

I personally don't trust any spreadsheet I could come up with as I'm just not that smart . My plan (for now) is to do ROTH conversions just up to the 15% tax bracket until age 70. ORP calculator shows I'll be in this bracket indefinitely. Do I trust it? Not exactly. But between these conversions and the fact that 2/3 of my PF is in after-tax/some ROTH currently, it's about the best I can do, particularly since I don't want to over think it.

Having tried off and on for several months, I'm finding I may not be able to build a spreadsheet that I'm completely confident in either. The deeper I go, the deeper it gets. But as it stands now, if I manage income to fill out to the 15% bracket, though it meets our spending needs, it's likely we'll have income in the 25% bracket from age 70 to end of plan (recognizing sequence of returns is unpredictable). Seems foolish to just accept that, especially since I fully expect effective rates to increase in the decades ahead. Still working at it, may be chasing my tail...but not all that hopeful.

 

[pb4uski]

I must admit I do not understand the logic, here is why, what do I have wrong?

If one where to convert to a Roth @ 30K per year for 10 years between age 60-70 you will subtract 300K from the portfolio and lowered the required RMD. However at age 70 only about 4% of that would be subject to withdrawl or 12K on the 300K you reduced and a tax of 25% that is $3,000.

However you would have paid tax at 15% total or $45,000 and permanently lost the earnings on that amount. Just in the 10 years this would have been implemented you would forgo earnings of $14,081 at a 5 percent return and $28,987 at a 7 percent return. Along with the 45K of tax paid this is 20 years to make this back up, excluding the effect future earnings foregone on the already taxed portion past age 70 . What am I seeing wrong?

Let's say you start with $300k of tIRA and $50k of taxable money at age 60.

If you convert $30k at the beginning of each year and pay 15% in taxes from the taxable funds then at the end of 10 years your tIRA, taxable account and Roth would have $92k, $19k and $396k respectively. (FV of cash flows at 5% and 4.25% (5% after-tax) for the taxable account).

Let's say that beginning at age 70 your SS puts you into the 25% bracket so all tIRA withdrawals are now taxed at 25%

If you effectively convert the $92k tIRA to an after-tax amount at 25%, you get $69k and have total after tax funds of $484k ($79K + $19k + $396k).

If you don't convert, at the end of 10 years you have a $489k and $76k in your tIRA and taxable accounts.

However, if due to SS your RMDs are effectively taxed at 25%, the after-tax value of the tIRA is only $367k, and with the taxable account added in the after-tax total is $442k - substantially less than the $484k future value if you do Roth conversions.

I think part of what you may have been missing is the 5% tax-free growth of the Roth IRA.

 

[Peter]

Those of us considering ROTH conversions before 65 also have to watch out for income over $85K in the two years before Medicare, as that will result in indefinite higher Medicare premiums.

Not sure I understand this. I know that Part B payments go up on a sliding scale once your MAGI goes above $85,000. But if your MAGI goes down again, the part B cost also goes down. You do have to fill out a form, but I don't see that the higher cost is locked in for ever.

 

[NW-Bound]

...
I think part of what you may have been missing is the 5% tax-free growth of the Roth IRA.

+1

I have been doing an example spreadsheet, and am about to make a post when I see that someone else already explained it.

If the tax rate that you are paying for the tIRA-to-Roth conversion amount is the same as the future tax rate on tIRA withdrawal at RMD, then it is a wash. If the former is lower than the latter, then you've won by doing conversion.

Another thing to consider is that even if the two tax rates are equal, Roth IRA has the advantage of having no RMD, hence gives you some flexibility if you are going to leave something to your heirs.

 

[Animorph]

+1

I have been doing an example spreadsheet, and am about to make a post when I see that someone else already explained it.

If the tax rate that you are paying for the tIRA-to-Roth conversion amount is the same as the future tax rate on tIRA withdrawal at RMD, then it is a wash. If the former is lower than the latter, then you've won by doing conversion.

Another thing to consider is that even if the two tax rates are equal, Roth IRA has the advantage of having no RMD, hence gives you some flexibility if you are going to leave something to your heirs.

Even if the tax rates are equal for Roth conversion and tIRA RMD's the Roth comes out ahead because of the greater after-tax value the Roth shelters from taxes. That makes it worth Roth converting at 25% tax rate if RMD's are going to come out at 25% tax rate. Providing that the Roth conversion taxes are paid with taxable funds and the full tIRA withdrawal is Roth converted.

 

[NW-Bound]

The biggest problem with making long-range planning for income optimizing and tax reducing is not potential tax code change but the unknown future investment returns.

FIRECalc says that at my current WR, by the time I get to IRA RMD age, the expected or average value of our IRA/401k will push us deep into the 25% tax bracket. And that is without taking SS early.

So, under the average scenario, if we take SS early we will spend less on IRA and will have even more at RMD age. The even higher RMD can push us past the 25% bracket into the 28% bracket.

If we do not take SS early, than the higher SS + lower RMD can still get us to the 28%.

Which of the above scenario is better? I guess I need to check into finer details. I am going to delay that for a few years as I cannot touch SS yet. I cannot even touch IRA (except for Roth conversion) as I am not yet 59-1/2.

One thing I have thought about, which appears to be a sure thing is Roth conversion. It looks like one either breaks even or wins with that strategy.

 

[walkinwood]

I must admit I do not understand the logic, here is why, what do I have wrong?

If one where to convert to a Roth @ 30K per year for 10 years between age 60-70 you will subtract 300K from the portfolio and lowered the required RMD. However at age 70 only about 4% of that would be subject to withdrawl or 12K on the 300K you reduced and a tax of 25% that is $3,000.

However you would have paid tax at 15% total or $45,000 and permanently lost the earnings on that amount. Just in the 10 years this would have been implemented you would forgo earnings of $14,081 at a 5 percent return and $28,987 at a 7 percent return. Along with the 45K of tax paid this is 20 years to make this back up, excluding the effect future earnings foregone on the already taxed portion past age 70 . What am I seeing wrong?

But you'll have to pay tax on the delta amount in the IRA every year after you turn 70 & it will increase as your RMD %age increases. And you haven't taken the increase in the value of the $300,000 in 20 years. Right?

 

[NW-Bound]

...
Providing that the Roth conversion taxes are paid with taxable funds and the full tIRA withdrawal is Roth converted.

But that money drawn from taxable funds to pay taxes could have been left there to accumulate capital gains, which can be tax free if one is in the right bracket.

There are so many moving parts! I think the gummint, either knowingly or inadvertently, has created these complex tax codes so that the citizens spend all their time trying to "optimize" their taxes, and keep their nose to the [-]grindstone[/-] keyboard and forget to protest. Good diversion, that.

 

[pb4uski]

.....I think the gummint, either knowingly or inadvertently, has created these complex tax codes so that the citizens spend all their time trying to "optimize" their taxes, and keep their nose to the [-]grindstone[/-] keyboard and forget to protest. Good diversion, that.

Knowingly? You're kidding, right? They aren't that smart.

 

[NW-Bound]

I dunno. One thing I have learned over the years is not to underestimate the other guy.

 

[Lsbcal]

You guys are making me laugh. Time to go to bed.

 

[Independent]

Is the tax really all that severe? Lets assume at age 70 single male will need to RMD 4% of a million dollar portfolio. Also start taking SS at 3K per month or 36K per year giving a 76K annual income. At 40K of income and 36K of social security for a single person the additional taxable income would be:

Test 1: 85% of 36,000 = $30,600

Test 2: 1/2 SS Benefits : $18,000
Combined Income $58,000
Less second threshold $34,000
Excess above 2nd threshold: $24,000
85% of excess: $20,400
TOTAL TEST 2 $38,400

Test 3
Provisional Income $58,000
Less 1st threshold 25,000
Excess above 1st threshold 33,000
50% of excess above 1st thresh 1 6,500
35% of excess above 2nd thresh 8,400
Total Test 3 $24,900 equal 69 percent of SS

Taxable income would be $64,900 less standard deduction of $6,500 and personal exemption of $3,950 leaves taxable income of $54,450 and a tax for a single of $9,468.75 or 12.5% of total income based on 2014 rates. This is 23.67 percent of the total 401K withdrawl so to take an early 25% tax for a single to convert to an Roth IRA would make very little sense in this case, and if you are making a lot more than this I think you should be patting yourself on your back for being better than 90% of all other retirees.

An excellent article I loved it

The complexity here is that the marginal tax rate includes not only the tax on the IRA withdrawal, but also the additional tax on SS that the IRA withdrawal generates.

That sounds confusing. The simple thing is to run the same math you've done above, but with a $30,000 IRA withdrawal. I think you'll find that your FIT is about $4,600 lower than it is with a $40,000 IRA withdrawal.

That's a marginal rate of 46% on the extra $10,000.

What's happening is that the IRA withdrawal is taxed at about 25%, for $2,500 In addition, the extra $10,000 of IRA withdrawal makes an additional $8,500 of the SS benefit taxable, for another $2,125.

If I knew that I was going to be in exactly this position after RMDs kick in, then trad=>Roth conversions prior to 70 would make sense when I'm in a 25% marginal tax bracket.

Of course, it's hard to know 10 years in advance that I really will be in exactly this situation.

 

[Independent]

There are so many moving parts! I think the gummint, either knowingly or inadvertently, has created these complex tax codes so that the citizens spend all their time trying to "optimize" their taxes, and keep their nose to the [-]grindstone[/-] keyboard and forget to protest. Good diversion, that.

I'm thinking about human nature. Let's imagine two tax systems.

1. A very simple system where it's easy to see that I will pay $10,000.

2. A very complex system, where it looks like I could pay $15,000 if I take the easy route. However, by studying the tax law, maximizing deductions, tax deferrals, etc. I can get my taxes down to $10,000.

Personally, I'd prefer 1. However, I think a lot of my fellow voters really prefer 2.
Maybe they wouldn't say that if the two choices were laid out this clearly, but in practice, the $10,000 payment is more palatable in the second case because they figure they "out-smarted" the tax guy.