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.