Many people are unaware that their social security benefits may be subject to tax when they retire. Up to 85% of these benefits can be subject to both federal and state income taxes. Does that get you mad? Many of my clients refer to this as “double dipping,” when they learn of it. When FDR signed social security into law, he promised that the benefit would never be taxed. And that lasted until 1983 when Tip O’neil and Ronald Regan came to a compromise which left SS benefits taxable. At the time, a threshold was set and only those with income above those amounts were subject to the taxes. As a result this was only going to affect Americans who were quite well off. However, since the threshold amounts were not indexed for inflation, it is very common today for middle Americans to be taxed on their Social Security benefits.
It works like this: First the IRS will calculate a figure called your provisional income (PI). Then they will compare that to their baseline or exclusion figures. If your PI is greater than $25,000, 50% of the amount of will be subject to tax. For every dollar over $34,000 in PI, 85% of that will be taxed. For married couples filing jointly, the exclusions are thresholds are $32,000 and $44,000 respectively. For every dollar over $34,000 in PI, though you may be in a 15% tax bracket, your marginal tax rate would be 28% because not only is that dollar getting taxed, its causing another $0.85 of your Social Security dollars to be taxed. $1.85 times 15% = $0.28 or 28%. If you’re in a 25% bracket, your marginal rate is 46.25%!
The good news is that through an awareness of these laws and some proper planning in many cases we can reduce or even eliminate this tax from having an effect. The key is not necessarily to spend less but to have the right assets available to you in retirement. We accomplish this by dividing up your assets into three major categories of retirement assets: 1) Fully taxable such as 401k, 403b, IRAs, etc. Every dollar of these funds is taxable when withdrawn. 2) Partially taxable funds. Investments such as stocks and bonds can have three basic kinds of income: dividends, interest and capital gains. All three types of income are considered taxable and can contribute to your social security being taxed. Even tax free interest, which isn’t itself subject to taxation, is added into PI for the purpose of calculating how much of the SS benefits will be taxed. 3) Non-taxable resources, such as government zero coupon bonds (series EE), principal, gifts, and Roth IRA funds are all completely tax free and will not contribute to your social security being taxed.
By adjusting the mixture of assets among the three classes, and scheduling the withdrawals we’re able to control how much provisional (as well as taxable) income a retiree will have in a given year. At the same time, we’re able to ensure that we provide sufficient cash flow to meet income needs. The earlier one begins to plan for this, the more flexibility there is in creating the right asset mix.
While many people have almost all of their savings in pretax vehicles on retirement, there are strategies available to shift the mix around. Conversely, it does make sense to have some of the first category funds available at retirement to take advantage of the low marginal tax rates that are available without triggering the tax on Social Security.
For a free personalized report on how you can minimize the taxation of your Social Security benefits, feel free to contact us and we can schedule an appointment.