Social Security is a powerful income stream. But for most retirees, it’s not enough.
Conventional wisdom says that workers should use tax-deferred retirement accounts to make up the difference between Social Security payouts and what’s needed. That approach, however, has significant drawbacks: required minimum distributions and a lack of longevity.
“In 1952, when the modern portfolio theory was first put on paper, the average male was going to live less than 15 years in retirement,” says Eliot Omanson, President of Sage Financial. “Today, it’s more than 25 years for many retirees.”
Social Security benefits weren’t taxed until 1983 – years after Congress established the IRA and 401(k). Now that they are, retirees can benefit significantly from another type of retirement account – one that doesn’t have an RMD and features tax-free distributions.
Enter the Roth IRA.
Established under the Tax Relief Act of 1997, the Roth is an excellent tool for reducing taxes and maximizing lifetime after-tax Social Security income. Combined with traditional IRAs and 401(k)s, Roths also allow clients to stretch their nest eggs further than they could with any one type of account.
A tax-efficient retirement strategy
One of the main benefits of a Roth is its provisional income calculation (PIC) – the formula the IRS uses to determine Social Security benefits taxation. The PIC is a combination of gross income, tax-free interest and one-half of a taxpayer’s Social Security benefit. Tax-deferred distributions count as gross income, but Roth contributions don’t.
So how can clients use this to their advantage?
“With two buckets to draw from – a Roth and traditional IRA – you can structure things to realize significant tax savings while also keeping the RMD in check,” says Omanson.
Consider a client who’s collecting Social Security and has stashed significant savings in both Roth and traditional accounts. He has an annual retirement income goal and needs to take distributions in order to fill the retirement income gap.
If he uses tax-deferred dollars to make up the difference, he’ll pay significant taxes on both distributions and benefits. If he covers the difference with a Roth, though he’ll pay little to no tax until age 70 ½ – and then will face massive tax liabilities due to the RMD of their traditional accounts.
A far more tax-efficient strategy, then, is to split the Social Security deficit between traditional and Roth accounts from the start. The Roth income will keep the client’s tax bracket and benefits taxation low throughout retirement, and drawing down tax-deferred accounts will reduce the RMD and consequent taxes later on.
Similarly, a combination of Roth and traditional distributions makes it more feasible to delay Social Security until 70. With sufficient savings in both buckets, a client could live on distributions alone in early retirement, paying taxes on half of her income or less. When she collects, she’ll have a 32 percent higher benefit that will allow her to draw less from both accounts, further reducing her taxes while hedging against longevity risk.
Historically low tax rates make Roth contributions an attractive option for today’s workers.
“We can’t guarantee anything, but if we look out 10 to 15 years from now, tax rates are going to have to be higher at some level,” says Andrew Rafal, President and Founder of Bayntree Wealth Advisors.
For a client at peak salary – who can afford to contribute with after-tax dollars – a Roth account is a solid hedge against future income taxes.
Leaving a legacy
Unlike traditional IRAs, Roth accounts are ideal for estate planning. When the original owner dies, a spouse can inherit the account with no fees, taxes or RMD -- as if they had owned the funds all along. A non-spouse beneficiary has two options: take a tax-free lump sum or transfer the funds to an inherited Roth IRA account.
The inherited Roth is almost as powerful as the original.
“The RMD is based on the life expectancy of the inheritor, which allows it to produce three to four times the income than if the assets were in a different vehicle,” says Omanson. A 50-year old inheritor may only have to take one-thirtieth of the funds per year – also tax-free – while the rest is left to grow. For a retiree with a maxed-out Social Security benefit and assets to spare, then, Roth contributions (and conversions) might be the best way to leave a lasting legacy.
As Roth accounts grow more popular, some planners have proposed an unorthodox approach: keep working, collect Social Security early and contribute those benefits to a Roth. The hope is that the Roth funds will continue to grow well past 70 – when Social Security stops maturing – and that investors will come out ahead once they stop working and take distributions.
Given a higher tax bracket, a higher PIC and the earned income penalty on Social Security benefits, however, that strategy doesn’t pan out.
“If you took a high earner with the maximum Social Security benefit – about $32,000 per year – just drawing early reduces them to $23,000,” says Omanson. “Combined with the tax hit they’re also going to take through the PIC, they’re looking at a 20-plus percent total hit.”
The numbers aren’t much better for lower earners or workers who wait until full retirement age to collect – particularly if they’re married.
“Even if they’re in the 15 percent tax bracket to begin with, they’re looking at an 11 to 12 percent hit with this strategy,” Omanson says. “I meet people all the time who have run a break-even analysis on Social Security, but they always forget about the PIC and spousal benefits”
Options for late starters
Even with the “work-while-collecting” strategy off the table, clients still have options if they’re closing in on retirement without having contributed to a Roth. At age 59 ½, IRA and 401(k) holders can start doing conversions. They’ll have to pay taxes on the converted amounts, but if they gradually shift funds over five to 10 years, they can avoid higher tax brackets and the Social Security taxation threshold.
For late starters who are already maxing out their contribution limits, certain life insurance products can act like Roth accounts, allowing owners to draw down funds late in retirement. They won’t have the same rates of return as an actual Roth, but given the potential tax savings, they can still work in a client’s favor.
The need for tax diversification
All in all, the Roth IRA is one of the best tools for protecting clients against taxes in retirement. While investors often think about diversification in terms of market size, company size and location, a Roth account provides the tax diversification necessary for hedging against longevity risk.
The coordination of Roth distributions, conversions and Social Security collection also present a perfect opportunity for advisors to build their clientele and partner with other professionals.
“This is probably the single most complicated aspect of someone’s retirement, so we always stress that clients work with a CPA and a financial advisor to identify what the tax consequences will be,” says Omanson.