What You Need to Know
- The sudden increase in income from claiming Social Security or taking RMDs can cause a tax increase that can catch clients off guard.
- Social Security benefits are taxed when total income crosses a certain threshold.
- Drawing from taxable retirement accounts earlier can reduce RMDs later.
Today, more retirees understand the value of maximizing their Social Security benefits by delaying collection up to as late as age 70. This sudden increase in retirement income, and potentially even greater amounts at age 72 when required minimum distributions (RMDs) begin, can trigger higher taxes that retirees may not have anticipated. As an advisor, how do you help your clients plan for this tax increase?
Start by Maximizing Social Security Income
Many retirees know that the later they file for Social Security, up to age 70, the higher their benefits. Most workers with retirement accounts, such as IRAs, SEPs, 401(k)s, 403(b)s and other defined contribution plans, also realize that they must start withdrawing funds from these accounts by age 72.
What they may be missing, though, is the need for managing the sequence and amounts of withdrawals from their retirement and personal investment accounts with a focus on the tax consequences, including taxation of their Social Security income.
Although Social Security income is taxable, not all Americans will be affected by or have the ability to manage this taxation. Those whose only or major source of retirement income is Social Security will fall below the minimum taxation thresholds.
On the other end, those with substantial retirement income and assets will be above the upper taxation thresholds, and 85% of their Social Security will be taxed. For those in the middle, however, the opportunity to manage specific income streams and account withdrawals can have an effect on their tax liability during their retirement years.
Along with the decision of when to claim Social Security benefits in their late 50s, the timing of withdrawals from taxable retirement accounts can be considered as early as age 59 ½, when withdrawals from these accounts are allowed to begin.
For retirees hoping to start collecting Social Security at full retirement age or later, drawing down fully taxable retirement account balances prior to age 72 can be used to bridge the income gap in the intervening years.
The resulting tax advantage from lower retirement account balances when RMDs begin is to lower adjusted gross income (AGI) and therefore taxation. The retiree’s larger Social Security income, due to waiting to collect, is given a tax advantage since only 50% of it is used in the taxation calculations.
The Effect of RMDs
The IRS has very specific rules about RMDs, and retirees cannot keep retirement funds in their accounts indefinitely.
RMDs are the minimum amount retirees must withdraw from their employer sponsored retirement accounts, traditional IRAs, and IRA-based plans such as SEPs, SARSEPs and SIMPLE IRAs each year. Roth IRAs do not have required withdrawals until after the death of the owner.
Starting in 2020 with passage of the SECURE Act, withdrawals from these accounts must start no later than age 72. The exact date that distributions are required to begin is April 1 of the year following the calendar year in which the retiree reaches age 72 or retires in some cases.
For a certain segment of retirees, RMDs can be a major consideration and source of increasing the combined income that is used to determine Social Security income taxation.