If you’re worried about outliving the nest egg of money you've saved for retirement, you might be considering claiming Social Security benefits early so your investments have more years to continue to grow untouched. Unfortunately, this strategy does not take into account how your retirement benefits are taxed when you receive Social Security benefits early.
Taking early benefits can trigger something that is referred to as a “tax torpedo,” which occurs when you take a distribution from your IRA or 401(k). A distribution from these tax-deferred accounts increases your provisional income, which can potentially make your Social Security benefits taxable. To outmaneuver the tax torpedo, you need to understand how taxes are calculated on Social Security benefits and how to anticipate the effect of those taxes on your income in retirement.
How Benefits Are Taxed
Unless your retirement income is below a certain level, you will pay taxes on anywhere from 50% to 85% of your Social Security benefits. The calculation for determining your benefits is deceptively simple. You add together one-half of your Social Security benefits, plus all your other income, including tax-exempt interest. This calculated amount is called your provisional income. (For related reading, see: 10 Commonly Asked Questions About Social Security.)
Your provisional income is compared to a lower and upper base amount. For single retirees, the lower base amount is $25,000 and the upper base amount $34,000. For married couples, the numbers are only slightly higher at $32,000 and $44,000. If your provisional income is below the lower base amount, then you owe no taxes on your Social Security benefits.
If your provisional income falls between the lower and upper base amounts, then you owe taxes on up to 50% of your Social Security benefits. And if your provisional income is above the upper base amount, then you owe taxes on up to 85% of your Social Security benefits.
Your provisional income only determines how much of your Social Security benefits will be taxed. It does not specify how much you will owe on your taxable benefits. Those taxable benefits are taxed at your marginal tax rate, which is determined by your level of income.
Tax Torpedo Basics
There are two reasons why early benefits can take a mean tax bite out of your retirement income: When you take early benefits, your monthly benefit is permanently reduced. This means you have to take more money from your investment accounts to make up the difference, which increases your provisional income. This also means taxes will take a larger portion of a reduced benefit.
The lower and upper base amounts are not adjusted for inflation, which means more of your Social Security benefits will be taxed each year because of the cost-of-living adjustments. This issue can get worse as you age. To begin with, as of age 70½, you must take required minimum distributions from you IRA or 401(k) accounts, which can drive up your provisional income and therefore your tax bill.
In addition, many older retirees will need to access more money from IRA and 401(k) accounts to pay for medical needs, which will also increase their taxable Social Security benefits. (For more from this author, see: Often Missed Social Security Claiming Options.)
One of the best ways to understand the potential problems of the tax torpedo is to do the math to see how you end up paying almost 50% in taxes. An individual who is a single retiree has an annual income of $38,000 from his IRA, along with his Social Security benefits. His provisional income is well above the upper base amount, meaning he has to pay taxes on 85% of his Social Security benefits.
He decides to withdraw an additional $1,000 from his IRA this year. He assumes that this will only trigger an additional $250 in taxes, since he is in the 25% tax bracket. But pulling an additional $1,000 from his IRA causes $850 more of his Social Security benefits to be considered provisional income and that means he has to pay taxes at his marginal rate of 25% on that $850.
So he’ll owe a total of $462.5 in taxes on the $1,000 withdrawal: $1,850 x 25% = $462.50.
Avoiding the Tax Torpedo
The best way to keep your retirement protected from the torpedo is to wait as long as you can to take your Social Security benefits. For instance, Freddie is entitled to a Social Security benefit of $2,000 per month as of his full retirement age at 66. If he takes his benefits at age 62, he’ll only receive $1,500 per month. However, if he waits until age 70 to take his benefits, he’ll receive delayed retirement equal to 8% per year past his full retirement age, meaning he’ll receive $2,640 per month.
Altogether, that will come to $13,680 per year that he can access without dipping into his retirement accounts: $2,640 minus $1,500 = $1,140 more per month $1,140 x 12 months = $13,680 more per year.
Of course, waiting for Social Security retirement benefits is a simple but not easy solution, especially for the retirees most need to wait. According to research by William Reichenstein and William Meyer, retirees with assets equal to $250,000 to $600,000 are the most vulnerable to the tax torpedo. These are also the retirees who may feel particularly concerned about the possibility of outliving their assets.
If your portfolio falls within that range, it’s a good idea to calculate the tax burden of various withdrawal and claiming strategies so you can make the best choice for your financial situation.
Planning ahead for the expected and unexpected costs of retirement is the best way to make your retirement income last. Understanding how your Social Security choices can affect your taxes can help you keep more money in your pocket and be better prepared for when those unexpected costs strike. (For more from this author, see: Applying for Social Security Before Retirement Age.)
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