Today, more retirees understand the value of maximizing
their Social Security benefits by delaying collection up to as late as age 70.
This sudden increase in retirement income, and potentially even greater amounts
at age 72 when required minimum distributions (RMDs) begin, can trigger higher
taxes that retirees may not have anticipated. As an advisor, how do you help
your clients plan for this tax increase?
Start by maximizing Social Security income
Many retirees know that the later they file for Social
Security, up to age 70, the higher their benefits. Most workers with retirement
accounts, such as IRAs, SEPs, 401(k)s, 403(b)s and other defined contribution
plans, also realize that they must start withdrawing funds from these accounts
by age 72.
What they may be missing, though, is the need for managing
the sequence and amounts of withdrawals from their retirement and personal
investment accounts with a focus on the tax consequences, including taxation of
their Social Security income.
Although Social Security income is taxable, not all
Americans will be affected by or have the ability to manage this taxation.
Those whose only or major source of retirement income is Social Security will
fall below the minimum taxation thresholds.
On the other end, those with substantial retirement income
and assets will be above the upper taxation thresholds, and 85% of their Social
Security will be taxed. For those in the middle, however, the opportunity to
manage specific income streams and account withdrawals can have an effect on
their tax liability during their retirement years.
Along with the decision of when to claim Social Security
benefits in their late 50s, the timing of withdrawals from taxable retirement
accounts can be considered as early as age 59 ½, when withdrawals from these
accounts are allowed to begin.
For retirees hoping to start collecting Social Security at
full retirement age or later, drawing down fully taxable retirement account
balances prior to age 72 can be used to bridge the income gap in the
intervening years.
The resulting tax advantage from lower retirement account
balances when RMDs begin is to lower adjusted gross income (AGI) and therefore
taxation. The retiree’s larger Social Security income, due to waiting to
collect, is given a tax advantage since only 50% of it is used in the taxation
calculations.
The effect of RMDs
The IRS has very specific rules about RMDs, and retirees
cannot keep retirement funds in their accounts indefinitely.
RMDs are the minimum amount retirees must withdraw from
their employer sponsored retirement accounts, traditional IRAs, and IRA-based
plans such as SEPs, SARSEPs and SIMPLE IRAs each year. Roth IRAs do not have
required withdrawals until after the death of the owner.
Starting in 2020 with passage of the SECURE Act, withdrawals
from these accounts must start no later than age 72. The exact date that
distributions are required to begin is April 1 of the year following the
calendar year in which the retiree reaches age 72 or retires in some cases.
For a certain segment of retirees, RMDs can be a major
consideration and source of increasing the combined income that is used to
determine Social Security income taxation.
Many people do not realize they should include the amount
and timing of these distributions in their retirement planning or how the
additional AGI from these withdrawals can cause their taxes, including those on
their Social Security income, to increase.
Except for withdrawals that are received tax-free, such as
from designated Roth accounts, the withdrawals will be included in taxable
income.
Although RMDs may not be a major factor in the Social
Security claiming decision, every year more retirees are subject to taxation of
their Social Security income and should be aware of this issue.
Options for managing taxation
Evaluation and possible repositioning of assets prior to
retirement can also directly affect future taxable income based on whether
withdrawals are coming from income-producing or growth-oriented accounts.
There are several management techniques financial advisors
can offer retirees when creating a retirement financial plan that manages
taxation, including that of Social Security income. Lowering AGI, and resulting
taxation, in certain years is the goal to create the most consistent, highest
standard of living throughout retirement.
A shift of taxable account investments from income funds to
growth funds will lower AGI. Shifting securities and investments from
high-yield interest generating funds to lower income generating growth
investments can achieve the same purpose.
Funds may be shifted toward tax-deferred and/or
tax-preferred accounts or other financial products, such as funding 401(k),
403(b) or 457 accounts. Finally, converting regular IRAs into Roth IRAs may
result in taxable income up front, but those nontaxable Roth IRA withdrawals in
the future can maintain a lower taxable income.
Of course, financial products, when sold, may generate
elevated levels of AGI and therefore taxation in the years those gains are
realized.
As noted above, prioritizing and sequencing account
withdrawals is the final step in managing income tax. By analyzing Social
Security claiming and fund withdrawal sequence, the impact on net after-tax
income and standard of living in retirement can be quantified.
The value of retirement planning
A 2014 MassMutual study found that the happiest retirees say
they took specific steps to plan early, preferably more than five years out.
Those concrete steps include calculating the best time to start collecting
Social Security, saving more, creating a budget, and working with a financial
advisor. According to the study’s findings, 58% of the most satisfied retirees
had worked with a financial advisor prior to retirement.
Financial advisors who have Social Security expertise and
the understanding of tax consequences when withdrawing funds from retirement
accounts and other income streams are extremely well-suited to providing
retirement planning.
By offering comprehensive retirement financial planning,
financial advisors have the opportunity to help clients manage their income
tax, increase their standard of living, extend the longevity of their
portfolios, and leave a larger legacy.
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