In my article last month, “Are Extended RMDs a Gold Mine or Tax Trap?” I talked about whether it was always the wisest course for people, especially married couples, to take advantage of the new later starting dates for 401(k) plans and IRA distributions. When you take federal income taxes into consideration, it might not make as much sense to wait.
Now I want to look at a similar question about Social Security—whether it always makes sense for people to defer benefits until they’re age 70, especially married couples. As I discussed last time, these IRA and Social Security issues are intertwined.
A Hypothetical Couple
Let’s take a hypothetical couple whose normal retirement age is 66½ (at this point, we’ll ignore income from their pensions, IRAs, etc.).
If a couple have little or no outside income, including nontaxable income, after they reach their normal retirement age and before they reach age 73, then the Social Security benefits they receive before they turn 73 will not be taxed. It will usually be to their advantage to begin taking Social Security when they reach age 66½ instead of waiting until they are 70. The main reason is that they will enjoy up to six and a half years of basically income tax-free Social Security benefits, thanks to the SECURE Acts 1.0 and 2.0 and the fact that they no longer have to begin taking IRA withdrawals when they turn 70½. Once the couple is required to take minimum distributions upon turning 73, all or a significant portion of their Social Security benefits will be included in their taxable income.
There’s also a secondary reason for taking Social Security benefits at age 66½ (if there’s no outside income). This has to do with widowed spouses and the “single filer penalty,” which I discussed in my last article, and the way it penalizes surviving spouses when it comes to withdrawing from IRAs. (The way the math works, the surviving spouse would be subject to federal income taxes on IRA distributions at a rate that’s higher than what the couple would have been subject to while both spouses were still alive.) Surviving spouses are also subject to this single filer penalty on Social Security benefits. So by electing to take as much Social Security as possible, earlier rather than later, there will be less Social Security benefits payable after the death of the first spouse. That will blunt the negative effects of the single filer penalty.
These same principles apply if one of the spouses starts taking Social Security benefits at age 66½ while the other spouse waits until age 70, the object being to maximize the couple’s total lifetime benefits. Whether it’s all the benefits or just a portion that is deferred, the couple will have wasted at least three and a half years of significant tax-free money, something that could have been reinvested (at least what they weren’t living on). If the couple had taken the money and put it in tax-efficient investments, they could arguably have done better than they would have taking bigger Social Security benefits later—especially since those bigger benefits would have been taxable and triggered a single filer penalty. And as I said in the last article, that reinvested tax-free money also gets a full or partial stepped-up income tax basis when the first spouse dies, thus eliminating or reducing the income tax on the money’s growth.
Now let’s say the couple has passed the normal retirement age (without reaching age 73), and they still have outside income. A significant percentage of their Social Security receipts will be included in their taxable income—50% or more, up to 85%. They have to take this into account before they decide to take Social Security at age 66½ (in full or in part) instead of at age 70. Unless the outside taxable income is more than $75,000 a year, however, the effective marginal income tax rate on the Social Security benefits is likely to be not much more than 10%, at least under the current federal income tax laws.
We can see that by doing the math: Let’s assume the couple has $75,000 of outside taxable income each year, and that their total annual Social Security benefit at their normal retirement age would be $50,000. Their standard deduction is $27,700. Given these figures, their total taxable income would then be $89,800 (0.85 x $50,000 + $75,000 - $27,700). The marginal federal income tax on the $50,000 in Social Security receipts would be $5,177, or only slightly more than 10%.
However, if the couple waited until they were 70 to begin receiving all or some of their benefits, the math would change: 85% of the increase in their Social Security benefits would be subject to tax in the 22% marginal income tax bracket, or at an effective tax rate of 18.7% (22% x 0.85). Also, a larger portion of the couple’s lifetime benefits would likely be subject to the single filer penalty after the first spouse passes. The couple would also lose the advantage of being able to reinvest three and a half years’ worth of full Social Security benefits, missing the appreciation and step-up in tax basis on the money, all because they are speculating that they’ll get a larger lifetime benefit.
In both of these cases, with or without up to $75,000 of outside income, there’s no disadvantage in taking the Social Security benefits early, at age 66½, at least when taxes and the present value of lifetime benefits are taken into account. The disparity in anticipated lifetime benefits is not enough that account holders should be biased toward taking the benefits at age 70 instead—under the perhaps false assumption they’ll get more in benefits later. Under the principle that “a bird in hand is worth two in the bush,” there’s an opportunity cost they’ll pay by not taking those three and a half years of benefits early, spending or investing it themselves, getting that step-up in basis, and avoiding an increase in the single filer penalty to the widowed spouse.
Social Security Benefits And IRA Withdrawals
Now that we’ve done the Social Security analysis, it’s easier to make decisions about IRA distributions in light of the SECURE Acts 1.0 and 2.0. If a couple has little or no other outside income (taxable or otherwise), and thus get their Social Security benefits essentially income tax-free, it would normally make little sense for them to take significant voluntary IRA distributions before they turn 73, besides what they use for living expenses over and above (otherwise untaxed) Social Security. This is especially true if the voluntary IRA withdrawals would push 85% of their Social Security benefits into the 22% or higher income tax bracket.
On the other hand, if the couple’s outside income is already significant (say, $20,000 or more per year), they could still reasonably begin taking IRA withdrawals earlier than age 73, as long as doing so would not push them into a much higher federal income tax bracket on the voluntary IRA withdrawals. This is because the couple’s IRA benefits will be subject to income tax, regardless, and because taking IRA withdrawals earlier rather than later would allow the taxable income on the couple’s combined IRAs to be spread out over a larger number of years, thereby lowering their overall income tax brackets and minimizing the effects of the single filer penalty after the first spouse passes. This also allows for the stepped-up income tax basis on any appreciation in the larger amount of the reinvested proceeds as each spouse passes.
If, however, the outside taxable income exceeded $75,000, it would push a couple receiving $50,000 in annual Social Security benefits into the 22% tax bracket (from 12%) on any voluntary IRA withdrawals, after factoring in the 85% inclusion on the $50,000 in Social Security benefits (and, again, a $27,700 standard deduction for couples).
If the couple wants to maximize the after-tax funds available to the surviving spouse, another smart tax strategy may be for them to use a portion of their “early” Social Security benefits or IRA withdrawals to purchase small life insurance policies that cover both of them, again assuming the early Social Security benefits or IRA withdrawals do not push the couple into a significantly higher income tax bracket. The insurance proceeds would come to them tax-free.
Planning For Unmarried Individuals
I would like to add some final thoughts for unmarried individuals, who unfortunately cannot take advantage of the same significant tax benefits married couples can. The key for singles is still in their tax bracket. In their Social Security and IRA distribution planning, they will want to get their income into the lowest federal income tax brackets possible, even if this means forgoing a speculative larger total Social Security benefit over their lifetime.
For example, if single individuals plan to work until they are 70 and then retire, it probably won’t make tax sense that they begin withdrawing Social Security benefits at their normal retirement age. Likewise, they will normally see little tax benefit in withdrawing IRA moneys while they are still working if the withdrawals can be deferred until they turn 73 (which is now allowed under the SECURE Act 2.0). Once singles retire, however, it would normally be preferable for them to spread their Social Security benefits and IRA withdrawals over as many nonworking tax years as possible.
As I wrote in the last article, the circumstances will obviously vary in each instance, but the central point for advisors to bear in mind in each client’s case is that deferring the receipt of Social Security benefits or IRA distributions for the maximum period possible may not always make financial sense when the after-tax money is taken into account.
James G. Blase, CPA, JD, LLM, is a principal at Blase & Associates LLC. For more on the estate planning techniques described in this article, see Mr. Blase’s book entitled Estate Planning For The SECURE Act: Strategies For Minimizing Taxes on IRAs and 401Ks, available on Amazon.