By Clay Reynolds
A common assumption is that your tax bracket will go down in retirement. However, many middle-class Americans are surprised to find that their effective tax rate actually increases once they retire.
The culprit in many cases is how Social Security is taxed. Social Security benefits are taxed very differently than your other income. The amount that is taxable is based on your provisional income.
Provisional income is calculated as:
- All of your other income, plus
- Tax-exempt interest, plus
- 50% of your Social Security benefit
Depending on where this number falls, anywhere from 0% to 50%, or up to 85%, of your Social Security benefit can be subject to taxation. In the worst-case scenario, 85% of your Social Security will be taxed.
| Filing Status | 0% of Benefits Taxable | Up to 50% Taxable | Up to 85% Taxable |
|---|---|---|---|
| Single, Head of Household | Provisional income under $25,000 | $25,000 to $34,000 | Over $34,000 |
| Married Filing Jointly | Provisional income under $32,000 | $32,000 to $44,000 | Over $44,000 |
| Married Filing Separately (lived with spouse during the year) | N/A | N/A | Up to 85% taxable from the first dollar |
These thresholds have not changed since 1993 and are not adjusted for inflation, which is why more retirees get pulled into this range every year.
To look at it another way, while you are in this range, every $1 you take from your IRA can count as $1.85 of taxable income because it also makes more of your Social Security taxable.
Many middle-class Americans who like to hold a large cash position (more than they need for expenses or an emergency fund) often do not realize the tax burden their CDs could be causing because they are getting hit with the tax torpedo.
For example, assume a client has a $200,000 CD earning 4.5%. The gross interest is $9,000 per year. Below is the after-tax return they are getting if their Social Security is subject to 85% taxability.
| Federal Bracket | Approx. Tax on $9,000 Interest and $7,650 Additional Taxable Benefits | Net Annual CD Interest | After-Tax CD Yield |
|---|---|---|---|
| 12% | $1,998 | $7,002 | 3.50% |
| 22% | $3,663 | $5,337 | 2.67% |
| 24% | $3,996 | $5,004 | 2.50% |
This taxation eats away at the interest you earn on your CDs, and in many cases it goes unnoticed because many people do not factor taxes into their interest. They see on their statement or online that they are earning 4%, but forget that they are earning much less after tax, especially if they are in a tax torpedo situation.
There are several strategies that can help reduce this effect, both before and after claiming Social Security.
The first is less of a strategy and more of a mental hurdle: deciding how much cash you really need on the sidelines in interest-bearing products. It is important to have an emergency fund and to plan for big purchases (i.e., don’t put all your money in the stock market if you know you need to buy a car this year!). For any cash in excess of your emergency fund, it may make sense to invest it in a more tax-efficient way, whether through exchange-traded funds or a multi-year guaranteed annuity (MYGA), which allows you to lock in a rate like a CD without reporting the interest every year.
Strategies before claiming Social Security
- Roth conversions: This allows you to take advantage of the gap years between retirement and claiming Social Security. Since there is no Social Security income yet, any conversions are simply taxed at your tax bracket rate. This helps reduce the size of your future RMDs, which could otherwise create a tax torpedo situation.
- Delaying Social Security benefits to age 70: For those with a strong asset base, it may make sense to delay Social Security and draw from your IRA first. This allows you to use a portion of your IRA while possibly in a lower tax bracket before RMDs begin, while also increasing your future income by delaying Social Security. Social Security is unique because once you start claiming, your income will not dip below that amount. By raising your guaranteed income floor through delaying, you put less stress on your investments in the future, as opposed to claiming early, locking in a lower benefit, and potentially paying more in taxes.
Strategies after claiming Social Security
- Make all charitable gifts through a QCD: At age 70½, you can make charitable donations directly from your IRA through a Qualified Charitable Distribution. These distributions are tax-free and excluded from AGI. Once you are subject to RMDs, a QCD also counts toward satisfying your RMD.
- Use non-AGI sources for spending: This is why it is so important to have several different “buckets” in retirement, from pre-tax to Roth to taxable non-retirement dollars. This lets you take advantage of return of basis, Roth distributions, or HSA reimbursements for medical expenses you have kept track of.
- Asset location: Your asset allocation is the breakdown of your investment portfolio. From 30,000 feet, it answers what percentage of your portfolio is in equities versus bonds. Closer to ground level, it gets into the weeds on large-cap versus small-cap exposure or short-term versus long-term bond exposure. For this example, we will assume the portfolio is 60% equities (invested in ETFs) and 40% fixed income (invested in bonds). Asset location is which accounts those investments are held in. If your fixed income is held entirely in a brokerage account, all of that interest is taxable. However, through asset location you could hold it in a tax-deferred account like an IRA, or in a Roth, so the interest paid during the year is not taxed. There is more nuance to each person’s situation, but asset location can make a big difference for those who are claiming Social Security or are close to the IRMAA limits.
Lastly, keep in mind that municipal bonds avoid federal tax on the interest itself, but that interest is still included in the provisional income calculation for Social Security, so they do not help with the tax torpedo.
If you have any questions about the topics above or would like to explore your situation to see if any adjustments could benefit you, please feel free to reach out to our team at Bluespring Wealth. We would be more than happy to help.
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