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Social Security Tax Management Moves Upstream

What financial advisors need to know to capitalize on new opportunities.

Making the best financial decisions is complex, particularly when the ground shifts beneath your feet. Old rules-of-thumb may or may not apply, so early in the process of change, re-evaluating rules-of-thumb can be highly valuable both to advisors and to their clients. When advisors recognize and identify opportunities to save their clients from leaving significant money on the table, everybody wins. With all of the chatter about tax in the news, clients are even more confused. Smart advisors can use this opportunity to grow their business by having strategic and timely tax conversations with clients and prospects.

Much of the press that surrounds the changes brought about by the Tax Cuts and Jobs Act are focused on the “what”—what changed from past laws. Few are focused on the “so what”—given those changes, how can you make smarter decisions that keep even more savings in your client’s accounts?

One of the primary services that a financial advisor provides is to create better retirement outcomes for their clients. The Act represents a relatively significant tax cut for many retirees, but there are opportunities for advisors to help clients visualize the new tax landscape and make better decisions about which income streams to use at different points in retirement.

Clients often don’t understand the relationship between ordinary income and long-term capital gains or qualified dividends and the impact on their tax bill, leading to potentially significant tax inefficiency in their retirement strategy. With these new larger standard deductions and lower rates, there are more planning opportunities for higher income retirees and more opportunities to do something to avoid a very high effective marginal rate right after minimum distributions kick in. 

A Case Study

To illustrate the interactions between ordinary income, such as IRA withdrawals, Social Security benefits and long-term capital gains, we’ll introduce Jane Jones, who is single and has saved $600,000 in her IRA along with $250,000 in a brokerage account. She is 64 years old today. She plans to take Social Security this month (we’ll explore a better path for that decision in a future article) and will receive $2,000 per month, so she needs to decide which accounts she should withdraw from in order to generate the additional $26,000 plus the tax bill, while producing a high level of tax efficiency.

Jane’s initial plan is the most common among retirees, in which she claims Social Security benefits now and withdraws non-qualified funds to meet her income needs. Based on her investment mix, a reasonable estimate of ordinary income, her portfolio may produce in the form of bond interest is $4,000. A reasonable estimate of recognized long-term capital gains is $15,000. Given those estimates, it’s highly likely she will have no federal tax bill this year, meaning she only needs to withdraw $22,000 plus the bond interest from her non-qualified account.

This client would likely be pleased, primarily because she doesn’t know what she’s missed out on. She could have taken at least $3,200 more from her IRA while still paying no federal income tax. That’s particularly important, considering her minimum distributions combined with Social Security benefits are likely to meet her entire income need beginning at aged 70½.

Another option might be to withdraw the entire $26,000 from the IRA account to supplement her Social Security income. This has been a much more frequent pattern among retirees who expect their Required Minimum Distributions to be more than they need once they turn 70½. Especially considering the new, lower brackets and higher standard deduction, this is an option worth exploring. Instead of using non-qualified funds to supplement Social Security benefits, she leaves those funds to accumulate and withdraws $26,000 from her IRA. She is surprised to learn that her federal tax bill would be approximately $6,341, almost a 25 percent effective rate on the IRA withdrawal. A variety of interactions between Jane’s incomes interacted to produce this unusual result. I’ll break it down to three distinct steps to illustrate:

Step 1. Taxable Ordinary Income:

In the first case, Jane only had $4,000 of ordinary income in the form of bond interest. In the second case, she had $30,000 because she still had to pay tax on the $4,000 of bond interest, even though she didn’t spend it, but she also had to pay ordinary income tax on the $26,000 IRA withdrawal.

Step 2. Taxable Social Security:

The additional ordinary income caused a larger portion of her Social Security benefit to become taxable. In the first case, only $3,000 of Social Security benefits would be taxable as ordinary income, while in the second case, $20,400 would be includible as ordinary income.

Step 3. Taxable Capital Gains:

The combination of additional taxable Social Security benefits with the additional IRA withdrawal increases the portion of capital gains that fall into the 15 percent capital gains rate. In the first case, $15,000 of capital gain came through at a 0 percent rate, while in the second case, $14,800 of the $15,000 was taxed at 15 percent.

A final pattern to consider might be a blend of non-qualified withdrawals paired with IRA withdrawals. Let’s assume she takes $16,000 of non-qualified withdrawals and $10,000 from her IRA. Four thousand dollars of the withdrawals are ordinary income in the form of bond interest and the remaining $6,000 is basis from sales that generated our projected $15,000 of capital gains. With this pattern, we would expect about $2,339 in federal tax and significant savings over the IRA first pattern. We’re actually saving 40 percent on the $10,000 reduction in the IRA withdrawal. How did that happen?

This blend of withdrawals increased the taxable ordinary income from $4,000 of bond interest only to $20,000 of bond interest combined with IRA withdrawals. In turn, the additional income increased the portion of taxable Social Security from $3,000 to $15,500, but it kept all of the capital gain taxed at 0 percent. For a client who will likely have an RMD that creates significant tax inefficiencies later in life, understanding these interactions and focusing on the “sweet spots” where you can pay a reasonable level of tax early in retirement in order to avoid a significant hit later can be incredibly valuable.

Explaining how retirement income streams are taxed is no easy task, but consumers rely on advisors and financial institutions to help them make the best financial decisions. You may not need to explain the details of the calculation, but being able to show them how much of their benefit is taxable, and helping them avoid a tax torpedo where their effective marginal rate is much higher than they expected, can help them see the value of an advisor who understands the intricacies of retirement planning.


Joe Elsasser, CFP, is President of Covisum. All calculations were made using Tax Clarity.

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