Greetings! I trust that this will find you well and enjoying life.
The advantages of tax deferral are often emphasized when it comes to saving for retirement. So it might seem like a good idea to hold off on taking taxable distributions from retirement plans for as long as possible. (Note: Required minimum distributions from non-Roth IRAs and qualified retirement plans must generally start at age 70½.) But sometimes it may make more sense to take taxable distributions from retirement plans in the early years of retirement, while deferring the start of Social Security retirement benefits.
Up to 50% of your Social Security benefits are taxable if your modified adjusted gross income (MAGI) plus one-half of your Social Security benefits falls within the following ranges: $32,000 to $44,000 for married filing jointly and $25,000 to $34,000 for single. Up to 85% of your Social Security benefits are taxable if your MAGI plus one-half of your Social Security benefits exceeds those ranges.
Social Security retirement benefits are reduced if started prior to your full retirement age (FRA) and increased if started after your FRA (up to age 70). FRA ranges from 66 to 67, depending on your year of birth. Distributions from non-Roth IRAs and qualified retirement plans are generally fully taxable, unless nondeductible contributions have been made.
It can sometimes make sense to delay the start of Social Security benefits to a later age (up to age 70) and take taxable withdrawals from retirement accounts in the early years of retirement, to make up for the delayed Social Security benefits. If you delay the start of Social Security benefits, your monthly benefits will be higher. And because you’ve taken taxable distributions from your retirement plans in the early years of retirement, it’s possible that your required minimum distributions will be smaller in the later years of retirement, when you’re also receiving more income from Social Security. And smaller taxable withdrawals will result in a lower MAGI, which could mean the amount of Social Security benefits subject to federal income tax is reduced.
Whether this strategy works to your advantage depends on a number of factors, including your income level, the size of the taxable withdrawals from your retirement savings plans and how many years you ultimately receive Social Security retirement benefits.
Here’s an example. Mary’s single and wants to retire at age 62. She can receive Social Security retirement benefits of $18,000 per year starting at age 62 or $31,680 per year starting at age 70. She has traditional IRA assets of $300,000 that will be fully taxable when distributed. She has other income that is taxable (disregarding Social Security benefits and the IRA) of $27,000 per year. Assume she can earn a 6% annual rate of return on her investments and that Social Security benefits receive annual 2.4% cost-of-living increases. Assume tax is calculated using the 2016 tax rates and brackets, personal exemption and standard deduction.
One option is for Mary to start taking Social Security benefits of $18,000 per year at age 62 and take monthly distributions from the IRA that total about $21,852 annually. Alternatively, Mary could delay Social Security benefits to age 70, when her benefits would start at $38,299 per year after cost-of-living increases. To make up for the Social Security benefits she’s not receiving from ages 62 to 69, during each of those years she withdraws about $40,769 to $44,094 from the traditional IRA. Which is an amount approximately equal to the lost Social Security benefits plus the amount that would have been withdrawn from the traditional IRA under the age 62 scenario (plus a little extra to make the after-tax incomes under the two scenarios closer for those years). When Social Security retirement benefits start at age 70, she reduces monthly distributions from the IRA to about $4,348 annually.
Mary’s after-tax income in each scenario is approximately the same during the first 8 years. Starting at age 70 however, Mary’s after-tax income is higher in the second scenario, and the total cumulative benefit increases significantly with the total number of years Social Security benefits are received. And here’s an additional bonus to always consider, social security benefits are adjusted for inflation.
Don’t hesitate to contact us if you feel we can help in any way with your retirement planning.
Jeff Christian CFP, CRPC