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Mark Miller: Remaking Retirement

How Retirees Can Avoid the 'Tax Torpedo'

Some retirement researchers are challenging the traditional thinking on tax efficiency, Social Security, and drawdowns.

It's a long-standing principle of retirement drawdown strategies: preserve the tax-saving benefits of tax-sheltered investments as long as possible.

But there's no-one-size-fits-all rule here, and a growing number of retirement researchers are pointing to a different approach: tap tax-deferred accounts first in the early years of retirement in order to reduce the total lifetime tax burden. The idea is to use dollars in 401(k) or IRA accounts to meet living expenses--or convert a portion of these assets to Roth IRA accounts--before claiming Social Security in years when your marginal tax rate is lower than it will be after you start to receive benefits.

This approach takes advantage of Social Security's valuable delayed claiming credits while minimizing taxes on ordinary income. It also can help avoid or minimize taxes on Social Security benefits and Medicare income-related monthly adjustment amounts levied on high-income retirees, and the net investment income surtax.

"Drawing down strategically before you claim Social Security can reduce taxes and result in a significant increase in retirement income," says William Meyer, co-founder of Social Security Solutions. "Understanding this can be a critical 'aha moment' for a lot of people," he adds. "It's important for everyone to run the numbers."

Do-it-yourselfers probably can figure this out on a spreadsheet. But a growing number of financial planners use software to analyze these strategies for clients. And some excellent low-cost solutions are available for individuals, too. Meyer and Social Security Solutions co-founder William Reichenstein have developed a companion service, Income Strategy, which combines Social Security optimization with optimal drawdown sequencing. Another option is MaxiFi, developed by Boston University economist Laurence Kotlikoff, which incorporates his Maximize My Social Security software.

Sidestepping the 'Torpedo'

The objective with these strategies is to avoid--or minimize--what researchers have dubbed the "tax torpedo," so named because the unique pile-on effect of taxes levied on Social Security benefits does indeed look a bit like a torpedo at certain income levels when plotted out on a chart.

Social Security benefits were first taxed in 1984 as part of a comprehensive Social Security reform package signed into law the previous year aimed at stabilizing the program's finances. The original idea was to tax only relatively high-income beneficiaries, and that remains the case. But the number of people affected is rising. That's because Social Security benefits are indexed to wage growth and adjusted for inflation, while the income threshold levels used to determine the taxable amount of Social Security benefits are fixed by law and not indexed for wage growth or inflation.

The formula used to determine the tax on benefits is unique--and somewhat confounding. First, you determine a figure Social Security calls "combined income" (also sometimes called "provisional income"). This is equal to your modified adjusted gross income, or MAGI, plus tax-exempt interest plus 50% of your Social Security benefits. For most taxpayers, MAGI consists of everything in adjusted gross income except the taxable portion of Social Security benefits.

No taxes are paid by beneficiaries with combined income equal to or below $25,000 for single filers and $32,000 for married people filing jointly. Beneficiaries in the next tier of income--between $25,000 and $34,000 for single filers and between $32,000 and $44,000 for married couples filing jointly--pay taxes on up to 50% of their benefits. Beneficiaries with income above those levels pay taxes on up to 85% of benefits.

This MAGI zone is where the torpedo can hit. For each dollar of combined income above $34,000 for single filers and $44,000 for married couples, an extra $0.85 of Social Security benefits are taxed (until 85% of benefits are taxable, which is the maximum). In this income range, each additional dollar of MAGI causes taxable income to rise by $1.85. Thus, the marginal tax rate is 185% of the tax bracket.

Reichenstein ran an illustration for a hypothetical single filer who turned 66 in December 2021. We'll call him Paul. We assume that Paul will spend $5,000 monthly this year (with that amount increasing 2% annually for inflation) and that he has a portfolio of $750,000, including $650,000 in a tax-deferred account and $100,000 in a taxable account. We assume a life expectancy of 89.

We compared three strategies:

  • Conventional wisdom: Paul claims Social Security immediately, and follows the conventional approach of withdrawing funds from his taxable account until it is exhausted, and then funds from his tax-deferred account until it is exhausted.
  • Conventional wisdom plus delayed claiming: Here, Paul delays Social Security to age 70 but follows the conventional approach to drawing down his portfolio.
  • Roth strategy: Paul delays Social Security to 70. In 2022-25, he withdraws funds following the conventional approach, and then makes Roth conversions to fill the 22% tax bracket. These Roth conversions are taxed at tax rates of 0% to 22%. In 2026-45, he withdraws funds from his tax-deferred accounts to fill the 10% tax bracket. He then makes tax-free withdrawals from his Roth accounts to meet the rest of his spending needs. These Roth withdrawals provide the ammunition that allows him to avoid making additional tax-deferred account withdrawals that would have been taxed at 27.75%.

Lifetime federal taxes fall from $207,000 in the conventional wisdom strategy with a benefit claim at 66, to $92,000 in the Roth strategy. The Roth strategy adds $159,000 of total value after taxes, and two years of portfolio longevity.

"By making those earlier Roth conversions, your required minimum distributions from tax-deferred accounts are much lower, and you can make tax-free Roth withdrawals to avoid much of the tax torpedo," Reichenstein says.

The delayed Social Security claim plays an equally critical role.

If you claim before your full retirement age, or FRA, your initial benefit will be reduced a certain amount for every month you claimed early. If you filed 60 months before FRA, for example, your benefit is reduced by 30%--permanently. And if you delay your claim beyond FRA, you receive a "delayed retirement credit" for every month of delay, up to age 70. For example, waiting one extra year beyond FRA gets you 108% of the primary insurance amount--for life. Waiting a second year, until 68, gets you 116%.

A person with an FRA of 66 who claims at age 62, will receive a reduced benefit for the rest of her life--25% lower. Claiming at FRA is worth 33% more in monthly income than a claim at 62, and a claim at age 70 is worth 76% more.

Relatively few retirees delay their claim past their FRA: 20% of women and 19% of men in 2019, according to the Center for Retirement Research at Boston College. Financial planners advising clients on claiming will tell you that one of the biggest obstacles is misplaced worry that Social Security will somehow go bankrupt.

Worry about the program's ability to pay full benefits into the future is understandable. After all, the reserves of the combined Social Security retirement and disability trust funds are projected to be depleted in 2034. Absent action by Congress, that would force an across-the-board benefit cut of about 20%. But that is highly unlikely from a political standpoint.

"The most common error we see is 'I heard Social Security is going broke, so I'm claiming early' under the auspices of 'I'll get what I can get before it goes away,' " says Michael Kitces of the XY Planning Network.

"We spend a lot of time explaining how even if funding isn't changed, there is still enough money to pay 70% or more of benefits for the rest of the century even after the trust fund is depleted, and how if everyone takes a 30% haircut it will be 30% off whatever you were getting--which means taking early doesn't do much to mitigate the impact anyway," he says.

On his website, Kitces published an analysis demonstrating that delaying Social Security still is a good deal, even if reductions occur.

And I'm betting that won't ever happen.

Mark Miller is a journalist and author who writes about trends in retirement and aging. He is a columnist for Reuters and also contributes to The New York Times and WealthManagement.com. He publishes a weekly newsletter on news and trends in the field at RetirementRevised. The views expressed in this column do not necessarily reflect the views of Morningstar.