Hey guys, Mike Frontera here, back with another edition of Retirement Theory.
So today I’m going give a big slap in the face to conventional wisdom. And by doing so, hopefully convince you of why having a financial planner help you with your specific situation is so critical.... you know, rather than just relying on some guy on the Internet!
Well as you may have heard, it can really help to delay your Social Security benefits as long as possible. Heck, I’ve given that same advice before on my own blog! You’ve probably also heard that you should spend your IRA money last in order to defer your taxes as long as possible. Well, here’s one major reason why that could be just the completely wrong advice.
Taxes. Aha! Our ugly friend rears its head again, screwing up our good intentions. Well, what I’m talking about is what can happen to your taxes when you delay SS, delay IRA withdrawals, delay, delay, delay, and finally you can delay no more. Age 70. 70 ½ for the IRA. So what happens? Well, of course everyone’s situation is different, but let me show you an example of how you can delay yourself right over a tax cliff. And then I'll show you how to not do that.
Alright, so in this example we have Ron Revenue (or so he’s nicknamed at the IRS). He lives in NY because he really likes paying his taxes. And he’s single. And for the sake of this example, we’re using 2019 tax rates only. In real life those rates are subject to change, of course.
When Ron is 67 ½ years old he has the following:
(January 1, 2019)
He has a bank account with $200,000 in it that pays no interest, just to keep the tax picture very simple.
- An IRA account with $1,600,000 that grows by a hypothetical 5% per year
- A yet to be claimed SS benefit of $2000 per month
Ron needs to live on $40,000 per year. Going with the aforementioned conventional wisdom, he doesn’t touch his IRA nor his SS benefits, electing for them to hopefully grow instead. Instead he lives off of $40,000 of withdrawals from his bank account. He’s files as single and pays nothing in income taxes….yet. Fastforward 3-years to when Ron is 70 ½ years old. He still wants $40,000 of income. But now he has:
(January 1, 2022)
- A bank account with $80,000 in it. It still pays no interest as he’s drawn $40,000 per year for the last 3 years.
- He has an IRA account that is now worth $1,852,200
- A SS benefit claimed at age 70 of $2640 per month
Assuming his IRA account value was as above on 12/31/2021 and he turned 70 ½ on January 1st, his required withdrawal is $69,894.34. His total income with SS is $101,574.34. And now we have some problems. Well first and foremost is that he’s forced to take way more income than he needs to live on. Second, due to his income, his SS benefits are now 85%1 federally taxable. And again, due to his income, his Medicare premiums go up2. He’ll pay a higher premium on both part B and part D. He’s not too far over Medicare’s limit of income to pay standard premiums, but even $1 dollar over and you’re stuck with the higher bill. Again, something that may have been avoidable with better planning.
Now, let’s talk about his income tax rate. With his standard deduction of just $13,8503, he’s darn close to that 24% tax bracket3. Either way, he’s got a lot of income that was taxed at 22%. And oh yeah, he’s from NY! Well in NY most folks over 59 ½ get a state tax exemption on the first $20,000 of IRA withdrawals each year4. But his required withdrawal has ballooned to almost $70,000, so now he’ll have to consider almost $50,000 of that required withdrawal as taxable NY income!
What are some things that that Ron could have done to keep himself from falling so far off this financial tax cliff?
SS claiming age:Might it have made sense in Ron’s case to claim SS earlier while his income was lower and received more benefits tax-free? Remember, SS benefits are taxed based on a calculation of something called Provisional Income. It is entirely possible to receive benefits tax-free if your other income is low enough. It may also have helped keep his taxes lower after he reached age 70 ½.
Using zero or near zero tax rates:If you have the ability to take IRA withdrawals or make Roth IRA conversions and pay little to no taxes, it’s almost always worth considering. Take Ron for example. During his low-income years, he drew solely on cash from his bank account. After his standard deduction he had NEGATIVE income! He could have drawn a bunch of IRA money or converted IRA money to a Roth IRA and paid no taxes on it! What a missed opportunity.
Being aware of tax bracket thresholds:There is a huge difference when you take IRA withdrawals in the 12% tax bracket versus the 22% tax bracket. Simple math would tell you withdrawals at the 22% rate are almost double the tax of those at 12%. Might it have made sense for Ron to take a large enough withdrawals (or make large enough conversions) each year to stay just under that 22% rate? Remember, those withdrawals ultimately reduce what he’s forced to take out at age 70 1/2. It’s possible that with those lowered required withdrawals, he may not have had higher Medicare premiums. It’s also likely that he would have had less of that required withdrawal taxed at that higher 22% tax rate, and less of those withdrawals would have been subject to NYS tax as well.
So…do you have questions for me? Let me know. Give me a call at (518) 612-1060, or just visit me at www.retirementtheory.com . Do you follow me on Facebook? I think that you should. You'll see videos like these, and get blog and article shares on everything retirement planning. Once again, thank you for joining me. See you next time!