In a recent meeting with a family we serve, the conversation – as it often does – turned to Social Security. The question was, once again, whether it was best to begin receiving Social Security benefits at age 62 or wait until age 66 and 6 months, their Full Retirement Age (FRA) with Social Security. I was reminded how important this topic was to you, and thought you would find a more in depth look very helpful. Although there are a number of reasons why one person might claim at 62 while another claims benefits at 66 or beyond, allow me to focus this article on one specific aspect: taxes.
Social Security Income benefits are taxable to the receiver, but on a limited basis, and on a sliding scale dependent on the value of all income received. For simplicity’s sake, just know that up to 85% of Social Security Income is taxable. That is as opposed to 100% of a withdrawal from an IRA or 401(k). Thus, when you take money out of an IRA in retirement, all of that withdrawal is taxed at your ordinary tax rate. Social Security Income is only taxed at up to 85%, depending on how much income you earn from other sources (wages, pension, dividends, etc.).
Why is this important?
If you are building a retirement income plan, deciding whether to use Social Security Income to meet your expenses or using IRA money can have widely different results. Because Social Security Income is taxed to a lesser degree than other sources of income, you may wish to delay taking it and using IRA money first. This allows the Social Security Income to grow, meaning you’re deferring a growing and more tax-friendly asset than your IRA.
This example may help to clarify. Let’s say you could magically predict that your IRA would grow 8% next year. Social Security, on the other hand, is guaranteed to grow 8% each year that you wait to receive benefits after age 62. If you had to choose which account to use first for income, your IRA or Social Security, which would you elect? Let’s take a look:
$10,000 grows at 8% to $10,800, of which $10,800 is taxable (100%) when withdrawn, Taxed at 20% = $2,160 of tax owed to IRS
$10,000 grows at 8% to $10,800, of which $9,180 is taxable (85%) when received, Taxed at 20% =
$1,836 of tax owed to IRS
Difference in taxes owed =
$324 in favor of taking Social Security first.
Note that this difference occurs each and every time you receive a check, year after year. Even if we stop here and choose to neglect all of the other reasons for possibly delaying taking Social Security, can you see the value in just the tax savings? Of course you can … with our sample numbers it’s $324, over and over and over! And most people are not earning enough income to see the 85% rate I used in the example; most are closer to 50%, which makes the difference even more dramatic.
Imagine if I put a sign in front of our office advertising that we’re giving $324 to each person who is eligible for Social Security benefits, and we’ll continue paying that year after year. We’d have a line down the street!
The name of the strategy is ‘reversing the tax torpedo.’ It’s just one of many ways that you can increase the total value of your assets and income without even discussing rates of return on your investments in the market. While it may not be the best strategy for everyone, it’s certainly worth considering the tax impact before making an irrevocable decision. If you’re interested in this strategy and more, contact us for a deeper discussion.