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Friday, February 22, 2013

Reducing Taxes on Social Security Benefits: Part 3


In my first blog on this topic, Will Your Social Security Benefits Be Taxed?, I explained who will pay taxes on their Social Security benefits and who won’t. People whose retirement income comes almost entirely from Social Security won’t pay the tax.

Eventually, just about everyone else will because, like the Alternative Minimum Tax, the limits that trigger the tax are not adjusted for inflation.

In my second post, Calculating Taxable Social Security Benefits, I explained how the tax is calculated. Understanding how benefits are taxed is the precursor to understanding how the taxes might be reduced or avoided.

As I explained in the first two posts, nearly every form of income except Roth IRA distributions is included in the calculation of combined income that determines how much of your benefit will be taxable. Avoiding the tax isn’t as easy as avoiding income tax by investing in municipal bonds, for example.

There are, however, some tactics to consider that may reduce the taxability of your Social Security benefits by reducing future combined income.

Work Less

If earnings from part-time work after you retire is pushing you over the limit and making your Social Security benefits taxable, you could consider working (and earning) less to drop back down below the thresholds. Remember, though, that only the amount of combined income that exceeds the thresholds is taxed, so avoiding the taxes you would owe may not justify working less. You have to do the calculations.

Invest in Annuities

Annuities defer capital gains until you start withdrawing from them, so they won't increase the amount of your Social Security benefits that are taxable until then, either. I don’t like variable annuities as investments, but they might help with Social Security benefit taxes, depending on your situation. In general, I think taxes should be a secondary part of investment decisions and there are generally better investment vehicles available than variable annuities.

Traditional IRAs

Traditional (non-Roth) IRA’s are a mixed blessing.

Your earnings will compound inside the account without being taxed until you take distributions from them. This will protect them from income taxes before you begin receiving Social Security benefits. After you begin receiving benefits, a traditional IRA will protect earnings from making those benefits taxable. You can avoid income tax and taxable benefits simply by leaving the money in your IRA. . . until you are age 70 ½.

At age 70 ½, however, you must begin withdrawing Required Minimum Distributions (RMDs) from all traditional IRA accounts, so you can no longer hide them from regular income tax or exclude them from combined income. They will then count toward making a portion of your Social Security benefits taxable.

RMDs are calculated as a fraction of your IRA balance ever year after age 70 ½.  April 15th of the year after turning 70 ½, you will be required to withdraw 3.6% of your IRA balance whether you need it or not. The percentages decrease every subsequent year.

Should you decide to leave your money in your IRA after you retire to avoid taxes, and to continue tax-deferred earnings, there is a good chance (you hope) that your IRA balance will increase over the years. More money is good, but the even-larger RMDs you are creating may not be. They could make your Social Security benefits taxable, the so-called "Tax Torpedo" that I explained in the first two blogs on this topic.

Roth IRAs

Roth IRAs are the golden boys of retirement income taxes. You paid taxes on the money before you saved it in the Roth and from then on earnings were not taxable, nor are distributions, and distributions do not increase Social Security benefit taxability.

If all of your retirement income came from Social Security benefits and Roth IRA’s, Social Security taxes would not be a concern for you.

Under certain circumstances, you can convert IRA dollars into Roth dollars. To do so, you have to pay income taxes on the money when you take it out of the IRA and that may or may not improve your finances over the long run, depending on your specific situation.

Should You Convert?

If Roth IRAs are so wonderful after you retire (traditional IRAs were better before you retired because you got a tax deduction on the savings), why not convert as much of your IRA to Roth as you can?

Maybe, you should. But you need to consider the pros and cons.

When you save in a traditional IRA, you invest earnings and defer paying taxes on them until you withdraw that money. You can withdraw it over a very long time (but beginning no later than age 70 ½), so you can stretch out those tax payments. Bottom line, with an IRA, you pay taxes when you withdraw money.

Also notice this means that the longer you live, the more tax you will pay on IRA withdrawals. Should you take RMDs and only live to age 72, for example, you would only pay taxes on about 8% of your IRA balance.

A Roth is just the opposite. You fund a Roth with earnings that have already been taxed, but you don't have to pay taxes when you withdraw from the account.

So, is it better to pay taxes up front or at the end? Actually, there is no difference if the tax rates are the same at both times, but if your taxes are higher before you retire, a traditional IRA will come out ahead. If your taxes are higher after you retire, a Roth will come out ahead.

Unfortunately, your future tax rates are unpredictable. Consequently, many advisers suggest you save some in each type of account to diversify your outcomes.

I have used consumption smoothing software to evaluate Roth conversions for some clients and found that the outcomes ranged from a loss of about 1% of standard of living to a gain of 1.6% if they converted IRA funds to a Roth IRA. That is a meaningful, yet not dramatic, difference. 

I have also noticed that papers written on the subject of Roth conversions never consider how long you will live, but this makes a dramatic difference. It is possible that you will not live long enough to realize the tax savings of converting to a Roth.

Should you die before you would have withdrawn from an IRA, the taxes you would pay to convert go for naught. And since traditional IRA withdrawals can be stretched out for many years, the longer you live the more tax you will pay. How long you live can make a big difference in the outcomes.

Imagine that you are 55 years old and decide to do a Roth conversion. You pay $25,000 income tax on the money you convert from your IRA. You plan to begin IRA distributions at age 70, but die at age 65. That’s $25,000 you paid in taxes that you never would have had to pay and perhaps 6% a year of compound interest you might have earned on that $25,000 also lost. (At 6% a year, that $25,000 would have grown to $44,771 in 10 years.)

You have to run the numbers (better yet, have a tax expert run them) to predict (not determine) whether your future (possibly) higher tax bill might justify pre-paying taxes on the conversion amount and forgoing future earnings on the amount of those taxes.

I like using consumption smoothing software to see if it will significantly impact your standard of living, but in my experience, the arguments for converting are rarely compelling.

In my next post, I’ll describe an alternative strategy recommended by many advisers that combines tactics for maximizing Social Security benefits, maintaining control of your capital and its growth, reducing RMD that maybe helps you reduce those Social Security benefit taxes without paying taxes today.

5 comments:

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  4. Hey Dirk,

    Did you ever write the article referred to in the last paragraph, above? I don't see it in the archives. Thanks for your time, and thanks for a really great blog.

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  5. I'm embarrassed to say that I don't know! I write about whatever I'm interested in at the moment and it is possible that I didn't get back to that. It sounds like I was referring to consumption smoothing and I don't believe I have posted on that subject, though I'm in the process of doing that now, so watch this space!

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