In my last article, I wrote about Topping off your bracket with a Roth Conversion. Even as I posted it, I realized I missed a pretty large issue. You see, your Social Security benefits may be taxable if you:
- file a federal tax return as an “individual” and your combined income*is
- between $25,000 and $34,000, you may have to pay income tax on up to 50 percent of your benefits.
- more than $34,000, up to 85 percent of your benefits may be taxable.
- file a joint return, and you and your spouse have a combined income*that is
- between $32,000 and $44,000, you may have to pay income tax on up to 50 percent of your benefits
- more than $44,000, up to 85 percent of your benefits may be taxable.
- are married and file a separate tax return, you probably will pay taxes on your benefits.
*Note – Your adjusted gross income+ Nontaxable interest+ ½ of your Social Security benefits= Your “combined income”
It took less than an hour for a reader to point this out, so it’s time for a deeper dive on how you might be retired, collecting Social Security and never quite see a 15% marginal rate. It’s tough to explain any algebra problem that has more than two variables. I can solve them easy enough, but verbalizing is tough. So, today we’re going to assume a single retiree is collecting $20,000 per year in Social Security benefits. And for simplicity’s sake, no deductions other than the standard $5,800, and of course, the $3,700 exemption. Here’s where it gets good – I pull up a copy of TurboTax (disclaimer – I am a paid blogger at their site, but am not being paid for this article, I actually just love their software) and enter an IRA withdrawal amount. I do this in $1000 increments, and for each thousand increase in IRA withdrawal, I note the increase in Federal Tax. If the tax table tell you that your marginal rate is 15%, but you see your tax go up by 22.5%, 27.75%, or an insane 46.25%, you’ve entered what I call the Phantom Tax Rate Zone.
When you look at the marginal rate table, a single person is expecting their bracket to be at 15% right up till a taxable $34,500. It’s the nature of the phase-in of the tax on your Social Security benefit that makes your tax rise far more than this on the next incremental dollar withdrawn.
The question is whether you can use this to plan your retirement withdrawals a bit better. First, sit down and look at the numbers. If you are single and are actually going to collect $20,000 in Social Security benefits, the chart above applies to you. If not, you’ll need to run some calculations of your own, and see where your phantom rates kick in. Next, how much do you have saved in pre-tax retirement accounts? For the above example, say it’s $500K. That works out well, as the $20,000 Social Security benefit is approximately what a $50,000 earner would get at full retirement age, and the $500K nest egg should offer you a $20,000 per year withdrawal for a total $40K per year retirement income. Now, that $20K/yr withdrawal does hit the phantom 22.5% level, but no worse. It would take $800K or more, and a $32K/yr withdrawal to push you into the much higher 46.25% rate. Here’s where it gets interesting. By delaying your Social Security start date, your benefit increases by 8% per year delayed. During this time, you’d take larger withdrawals from your 401(k) or IRA accounts, and, if you don’t actually need the extra funds, use the Roth Conversion to pull more money out of the accounts. Note, the numbers shown here is using 2011 rates as that’s the current software I’m using. When you add your exemption, standard deduction, and the $34,500, you’re at a gross $44,000 withdrawal and remain in the 15% bracket. 5 years of this withdrawal/conversion combination and you’ve drawn down your pretax account by over $100,000, and increased your Social Security benefit by 40%.
I look forward to feedback on this, as I feel that the phantom tax rate, due to Social security being taxed at what I believe is a low threshold, is one of the most under-reported bits of financial news. It’s also a sad irony that one can work and remain in the 15% bracket, yet, if they save pre-tax and invested wisely, are doomed to pay 27.75% & 46.25% on a portion of their withdrawals. There are ways to avoid this, but only by planning ahead.
On Monday, I’ll reproduce the chart but for Married Filing Joint. Thank you to all those who have read this article.