Most people understand the potential cash-flow benefits of delaying the onset of Social Security benefits from the age of 62 up to age 70. Each year of delay will increase the baseline monthly Social Security payment by about 8%.
Many advisers spend time talking about the benefit of the increased guaranteed cash-flow strategy with their clients, but few consider the improved long-term, tax-planning benefits associated with the delay. Below are the advantages of using the delay strategy beyond just the improved lifetime income.
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Let’s discuss what many advisers see when talking with clients and prospects about the timing of their Social Security benefits. Taking benefits early when someone is eligible at age 62 may seem to be a logical way to enhance the monthly spendable income. Doing so may allow clients to delay distributions from their retirement accounts and allow them to continue to grow them on a tax-deferred basis.
An unintended consequence
If the client delays, the drawdown of their retirement accounts (we will call them IRAs for the remainder of this article), the IRA account can continue to compound on a tax-deferred basis. This can continue until the client reaches age 70 1/2, when they are forced to start taking the required minimum distributions. This sounds fine, but in doing so:
· The IRA has most likely grown because no funds have yet been removed, causing the required distribution to be larger due to the larger IRA year-end value.
· If the client’s spouse passes away, the survivor will no longer benefit from the joint-filing status.
This creates what we call “bracket creep,” and suddenly, the surviving client jumps tax brackets. Married filers can earn a taxable income of $75,300 and be taxed in the 15% marginal bracket. The figure for single clients is $37,650, or half of the joint amount.
Usually, spouses name each other as the primary beneficiary of each other’s IRA accounts, and the survivor now holds 100% of the IRA portfolio. After the passing of one spouse, the survivor will likely go from the 15% marginal bracket to the next marginal bracket, 25%.
They then also fail the provisional income test for their Social Security benefits. Now, they have up to 85% of the reduced benefit (Social Security Survivor Benefit) at the 25% federal income tax level for the rest of their life because of the reduced thresholds for single tax payers versus joint. We call this the “widow tax trap.”
Fixing the problem
So how do we mitigate this dilemma? We delay taking Social Security benefits if possible. With the ever-increasing baby boomer population living longer and longer, longevity planning is essential. Your client will not only enjoy the benefit of the annual increase in the future benefit caused by the delayed start of their Social Security benefit, they may also have room within their tax planning to begin drawing down their IRA or IRAs at the wider joint filing status thresholds.
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Clients can use this drawdown to live on, or if they do not need the funds, they can use the tax bandwidth to convert them to Roth IRAs. This strategy will reduce the value of the traditional IRA portfolio over time, and thus reduce the eventual required distribution amount. This strategy may also reduce the effects of the provisional income test on their Social Security benefits down the line. Roth IRAs have no required minimum distribution, and distributions take from them are tax-free.
Managing the distribution strategy or IRAs, in combination with the timing of Social Security benefits, can yield excellent cash-flow benefits for life and reduce the future tax burdens associated with deferring the drawdown of an IRA for too long. There are numerous strategies for making an impact on your clients’ long-range plans. This concept may not only increase their net after-tax cash flow for life; it also yields a tax-free Roth IRA benefit for each of them and their loved ones.
