Financial Strategies To Consider Before You Stop Working

When it comes to planning for retirement, savers often try to allocate as much money as possible in employer-sponsored retirement plans and IRAs. And why not?! The tax deferral features of these accounts may provide years of attractive growth without paying Uncle Sam any taxes until the time you start withdrawing money for your retirement.

But for some people moving close to or who are in the early years of retirement, making additional contributions to and/or preserving assets in tax deferred accounts might not always be the right choice. Specifically, one item to consider is the timing of when you want to begin receiving Social Security retirement benefits.

It might seem like a good idea, during the early years of retirement, to hold off on taking taxable distributions from retirement plans for as long as possible and filing to start Social Security benefits in order to meet your income needs. (though keep in mind that Required minimum distributions from non-Roth IRAs and qualified retirement plans must generally start at age 72.)

But sometimes it may might make more sense to pursue the opposite strategy: take taxable distributions from retirement plans in the early years of retirement while deferring the start of Social Security retirement benefits. Here’s why:

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, head of household, or married filing separately (if you’ve lived apart all year).

Up to 85% of your Social Security benefits are taxable if your MAGI plus one-half of your Social Security benefits exceeds those ranges or if you are married filing separately and lived with your spouse at any time during the year. For this purpose, MAGI means adjusted gross income increased by certain items, such as tax-exempt interest, that are otherwise excluded or deducted from your income for regular income tax purposes.

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.

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, head of household, or married filing separately (if you’ve lived apart all year).

Up to 85% of your Social Security benefits are taxable if your MAGI plus one-half of your Social Security benefits exceeds those ranges or if you are married filing separately and lived with your spouse at any time during the year. For this purpose, MAGI means adjusted gross income increased by certain items, such as tax-exempt interest, that are otherwise excluded or deducted from your income for regular income tax purposes.

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.

Mary, a single individual, 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 (before cost-of-living adjustments). 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 (compounded monthly) and that Social Security benefits receive annual 2.4% cost-of-living increases. Assume tax is calculated using the 2020 tax rates and brackets, personal exemption, and standard deduction.

This example is hypothetical and not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges which are inherent to investing.

Option 1. 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.

Option 2. 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–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.

If you are thinking about retirement, you should ask your financial advisor to analyze your situation and provide a side-by-side comparison of the options. You might be able to determine which scenario might yield the most “after tax” dollars during your retirement years. Not taking advantage of this planning opportunity could lead to your unknowingly choosing a less optimal strategy that could cost you plenty!

As always, I welcome any thoughts or comments! And if you have any questions about your situation, please feel free to email me at bill.pollak@lpl.com or call at (925) 464-7057.

Itineris Financial Advisors and LPL Financial do not provide legal advice or tax services. Please consult your legal advisor or tax advisor regarding your specific situation.