Your clients plan for their golden years. But those unaware of the Social Security “tax torpedo” could see their plans taking on water.
Here’s how the tax torpedo comes into play. Say a worker — we’ll call him Joe — retires at age 62 with $500,000 in a traditional IRA. Conventional wisdom says that Joe should collect Social Security benefits now so he can limit the amount he has to withdraw from his IRA.
Of course, since he’s collecting Social Security benefits at age 62, his benefit amount will be less than if he’d waited to collect. As a result, Joe still needs to withdraw some funds from his IRA to meet his income goals.
Here’s where the torpedo hits. Unbeknownst to Joe, those IRA withdrawals will trigger increased taxes on his Social Security benefits — which then pushes him into a higher marginal tax rate.
Why does this happen? Because IRA withdrawals and Social Security benefits are taxed differently.
One hundred percent of withdrawals from a traditional IRA are taxable. When it comes to Social Security, however, no more than 85% of benefits are taxable — and that percentage decreases as provisional income decreases. (Provisional income is any tax-free interest income plus adjusted gross income and 50% of any Social Security benefits.)
|Filing Status||Provisional Income||Taxable Portion of Social Security Benefits||Provisional Income||Taxable Portion of Social Security Benefits|
|Single||$25,001 – $34,000||50%||Greater than $34,000||85%|
|Married||$32,001 – $44,000||50%||Greater than $44,000||85%|
So as Joe’s provisional income increases, so does the taxable portion of his Social Security benefits. That can cause his effective tax rate to increase. Over the long term, the additional tax burden can have a big impact on the life span of his savings.
To avoid the torpedo, Joe should consider delaying Social Security benefits. In addition to keeping his provisional income lower, this also lead to a larger Social Security benefit down the road — and less in taxable IRA withdrawals as a result.
While this communication may be used to promote or market a transaction or an idea that is discussed in the publication, it is intended to provide general information about the subject matter covered and is provided with the understanding that none of the member companies of The Principal® are rendering legal, accounting, or tax advice. It is not a marketed opinion and may not be used to avoid penalties under the Internal Revenue Code. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements.
Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc.