The Importance of Social Security Planning
It is common knowledge that the longer you wait to take your Social Security benefits, up to age 70, the larger your monthly benefit will be. The breakeven age (where you come out better) is about life expectancy if you factor in the time value of money. However, when tax planning is incorporated into Social Security planning, the benefit of delaying benefits become much better.
Delaying Benefits Can Reduce Taxes
A typical couple who each were making $60,000 per year would have Social Security benefits of about $24,000 per year if taken at age 67, and would have to withdraw about $60,000 per year to have $100,000 in net after-tax cash flow in retirement. If they both can delay their benefits until age 70, each benefit would move up to $29,760, their IRA distributions would drop to $46,000 and their federal taxes would be 33% lower. Knowing what taxes will be paid can strongly influence your Social Security filing decision.
Social Security Effective Marginal Bracket™
It is critically important to understand taxes in retirement to avoid bad decisions. The couple above are in the 12% federal income tax bracket. However, their Social Security Effective Marginal Bracket™ is 22.2%. This is because each additional dollar of income they receive will cause another eighty-five cents of their Social Security benefits to be taxable.
If this couple wanted to take an additional $10,000 – net of taxes – out of their IRAs, they would have to take a gross distribution of about $13,000. The $3,000 in taxes is higher than the Social Security Effective Marginal Bracket™ of 22.2% because the money they must withhold to pay the additional taxes is also taxed, so they have to keep moving the distribution amount up until they reach the $10,000 net distribution.
A Complete Understanding of Social Security Taxation is Necessary
Due to the difficulty in understanding how benefits are taxed, it is easy to make errors in how much taxes are withheld on distributions. If too little is withheld, you not only could have a large tax bill, but you could also be subject to a penalty. If you would like to work through these pitfalls, please reach out to a Tax Acuity Approved Advisor™ on our contact page.
