Thursday, July 31, 2014

Your Retirement: Navigating the Social Security ‘Tax Trap’

If you haven’t discovered it already, up to 85 percent of your Social Security benefits could be taxed.

As financial advisors, we are often surprised by the number of prospective retirees who come to us for planning and are shocked that they have to pay taxes on their Social Security when they retire.

In fact, in 2012, Social Security beneficiaries paid a total of $45.9 billion in income taxes on their benefits. That’s right!

Sadly, for many people this taxation could be avoided or at the very least, significantly reduced.  You have to plan ahead for it – and that means understanding how taxes work in retirement.

So here’s how it works: First, to determine the taxability of your Social Security, you must take into consideration your combined income, also known as provisional income, which is arrived at by taking 50 percent of your Social Security benefits and adding that figure to all the other taxable and tax-free interest income you receive in retirement. Yes, even municipal bonds are considered in this equation.

If you file as an individual and your combined income is below $25,000, your benefits won’t be taxed at all. If your income is between $25,000 and $34,000, up to 50 percent of your benefits may be subject to tax. For income of more than $34,000, up to 85 percent of your benefits may be considered taxable income.

If you and your spouse file a joint return with combined income below $32,000, your benefits are safe. For income between $32,000 and $44,000, up to 50 percent of benefits may be subject to taxation, and up to 85 percent if combined income exceeds $44,000.

It is possible to have income in excess of these thresholds while keeping your benefits out of the hands of Uncle Sam. Let’s look at a case to see how this plays out.

Case Study:

A married couple, Jerry and Linda, are both 62 and have recently decided to retire. They’re income need is $62,000 per year. As it stands currently, they have $38,000 of income. So they will have to make up the shortfall of $24,000 ($62,000 - $38,000 = $24,000) from their investment assets.

Jerry and Linda have done a good job accumulating assets to make up for the shortfall between their fixed income resources and their desired income need. However, we want to distribute the assets in the most tax-efficient manner. After all, a dollar paid out in taxes is a dollar that never returns!

Current Income:

Interest and Dividends Income..$2,000

Social Security Income.........$18,000

Pension Income.................$18,000

Total Income...................$38,000

Current Assets:

Bank Accounts....$150,000

Mutual Funds.....$300,000

IRA..............$250,000

401K.............$300,000

Total Assets.....$1,000,000

Jerry and Linda obviously could draw $24,000 from any one of the accounts listed above. However, what option would allow them to access it without causing their Social Security benefits to become taxable?  Through our analysis, we found that they could distribute $15,000 from the mutual funds of which only $2,942 is taxable as a gain. The remaining $12,058 would be consider principal and is not taxable.

They could also distribute $9,000 from their bank accounts, which again would be non-taxable. Any interest accrued on the bank accounts is taxed as interest and dividends and is already accounted for in the combined income above.

So as you can see, we devised an income plan that allows them to attain their $62,000 income goal.  But does it muster up to our “tax free” goal? Let’s work through the calculation:

Interest and Dividends Income..........$2,000

50 percent of Social Security Income...$9,000

Pension Income.........................$18,000

Mutual Funds capital gain..............$2,942

Bank Accounts..........................$0    

Combined Income Total..................$31,942

It sure does with $58 to spare! You see, with proper planning Jerry and Linda were able to produce an income of $62,000 without causing one cent of their Social Security to become taxable. Had they made a different choice they could have had a combined income of $53,000 rather than $31,942, causing 85 percent of their Social Security to become taxable.

A fundamental part of any financial plan is the need for a strategy to help prevent or minimize the effect of income taxes on your wealth. If you do not have such a plan, you can lose significant amounts of money that you may never be able to recapture. There are numerous income-tax savings concepts at your disposal. Unfortunately, most people don’t use any, and many use the wrong ones.