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Christopher Jones, CIO at Edelman Financial Engines

Retirement Planning > Social Security > Claiming Strategies

Biggest Social Security COLA in Decades Could Push Retirees Over a Tax Cliff

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The largest Social Security cost-of-living adjustment since 1981, 8.7%, has good news written all over it. But an irritating sidebar accompanies that: higher taxes on Social Security benefits.

“There are some quirks in the tax code that can result in very high marginal tax rates in certain situations,” Christopher Jones, chief investment officer and executive vice president of investment management at Edelman Financial Engines, tells ThinkAdvisor in an interview. “So if you get a few more dollars of income and it pushes you into the 85% bracket, that can be pretty onerous.”

Jones recommends that retirees with sources that augment their Social Security benefits, such as investment accounts, “determine the best way to take money out of these to minimize their taxes.”

Back to good news about the big COLA: Medicare premiums will drop a bit in 2023. That means “the COLA won’t be offset” by the premium that’s deducted from folks’ Social Security benefits every month, Jones says.

Meantime, the 2022 bear market has caused workers’ 401(k) accounts to be hit substantially. The median balance for “the 60 to 65 age cohort is probably [about] $75,000 to $85,000,” says Jones, while the average balance for a 65-year-old is ”probably 15%-20% lower this year” compared to the approximate $250,000 the data suggested prior to 2022, according to Jones.

And that average balance is “heavily impacted by some pretty large 401(k) balances out there,” he notes.

Jones, author of “The Intelligent Portfolio: Practical Wisdom on Personal Investing from Financial Engines” (2017), was the third employee hired at the legacy Financial Engines, founded by Nobel laureate William F. Sharpe in 1996.

Before the 2018 merger of Financial Engines and Edelman Financial Services, Jones held the post of executive vice president and chief investment officer at Financial Engines.

ThinkAdvisor held a recent phone interview with Jones, who was speaking from his base in Santa Clara, California.

Amid the long-running debate about the Social Security system of the future, he forecasts “adjustments in the way benefits are paid and the way the system is funded, probably in the form of higher taxes.”

Here are highlights of our conversation:

THINKADVISOR: Will the 2023 large cost-of-living adjustment (COLA) increase result in Social Security recipients paying higher taxes on their benefits?

CHRISTOPHER JONES: Yes, that’s an unfortunate side effect of a big COLA, which this year is [8.7%]. That’s the biggest one we’ve had in a long time.

The marginal tax brackets that apply to Social Security income aren’t indexed to inflation. That means a higher proportion of those benefits, which are going up in nominal terms, are likely to be taxed. That’s usually at either 50% or 85%, depending on income level.

Those who augment their [Social Security] income with a pension or other annuity sources or from investments need to determine the best way to take money out of these investments to minimize their taxes.

That’s important for retirees. It can make a significant difference in the amount of after-tax money they get to consume.

The tax code is pretty obtuse for most folks, so figuring out how to optimize decision-making requires consulting with someone who has expertise in this area.

Can this large COLA push someone into a significantly higher tax bracket?

There are some quirks in the tax code that can result in very high marginal tax rates in certain situations.

So if you get a few more dollars of income and it pushes you into the 85% bracket, that can be pretty onerous.

But the COLA is still beneficial. It’s much better for folks who are living on Social Security to get the additional income to cover the impact of inflation than to not have it, though it can mean your tax bill will be a little higher next year.

The Medicare premium for health insurance coverage is set to drop in 2023. That appears to be good news. Is it?

Yes. It means the COLA won’t be offset by the Medicare premium.

But as great as it might seem, the reason it’s dropping is that last year the premium went up a lot because of a new Alzheimer’s drug that was approved.

Now they’re realizing that fewer people are taking advantage of getting it or are unlikely to get it. That’s why the premium is going to drop a bit this year.

Which provides more income for retirees: the average 401(k) account or Social Security?

Obviously, 401(k) accounts are down in 2022 because almost every asset class is down.

But the most relevant data I’ve seen from the big record keepers suggests that for a 65-year-old, the average 401(k) balance was on the order of about $250,000.

It’s probably 15% or 20% lower this year. That’s the average, and it’s heavily impacted by some pretty large 401(k) balances out there. Some people are able to accumulate $1 million or more.

What do you think the median 401(k) balance is, then?

For the 60 to 65 age cohort, it’s probably under $100,000 — something like $75,000 or $85,000. That’s a fairly modest number to provide for somebody over a lifetime.

About a third or so of people in that age cohort have both Social Security and pension income. So depending on their level of income, that will cover most of their needs.

But the trend has been to fewer pensions available to workers, right?

Every few years we’re seeing a cohort of retirees who have less and less access to pension income and who are more and more reliant on their 401(k) to fund their retirement.

The good news is that younger cohorts are saving more aggressively for retirement — though markets like we’re experiencing in 2022 don’t help. They set people back. So you may see people delaying their planned retirement age by a year or two.

What bearing does the large COLA have on someone’s decision to start taking Social Security now?

Whether you chose to take it now or wait until sometime in the future, you still get the benefit of the COLA. Future beneficiaries will benefit by whatever the change in the COLA is for next year.

Social Security is a “real annuity” — one that’s adjusted for inflation. That makes it very valuable because there aren’t very many annuities like that in the private market. And most people who are offered these don’t buy them.

What guidance can you provide on when to start claiming Social Security?

You want to maximize the lifetime value of those benefits, and that value is considerable. The stream of Social Security that most single folks get [now] is $600,000 to $800,000, on average.

For married couples, it can easily be over $1 million, in present value. So it’s a very, very significant part of the balance sheet for most people.

The best choice would be for the highest earning member of the family to typically wait to claim till they’re 69 or 70.

For every year you defer claiming, you get 6% to 7% — and in some cases, 8% — additional benefits for the rest of your life, adjusted for inflation. That’s a really powerful benefit, even with higher interest rates.

How does one integrate Social Security with a 401(k) plan?

The key is to maximize your benefits from Social Security by waiting until full retirement age, if you’re the highest earner in the family. If you have a spouse, they will have the advantage of getting half of that higher benefit as long as they live.

If you’re married to someone who has a higher benefit than you, you don’t have to be concerned about waiting until age 69 or 70. In general, taking your benefit at full retirement age probably makes sense.

What about the 401(k) component?

When you decide to retire and when you claim Social Security don’t have to be on the same date. Let’s say you retire at 62 or 64. So you’ll have a gap of a few years to fill in terms of paying your retirement expenses.

That’s where a 401(k) or other retirement savings can be really helpful. It can fill the gap until Social Security kicks in and provides most of the income.

Suppose you don’t have a 401(k) account. What might you do?

Part-time work is becoming increasingly popular with near-retirees and the recently retired so they don’t need to depend on their savings as much.

We’re also observing that a lot of people are doing the best they can to defer taking money out of their 401(k) plan. A typical pattern is waiting until their required minimum distribution begins, now at age 72.

People are using their 401(k) nest egg as a safety net, a pool or money to tap into if needed; but they’re preferring not to unless they absolutely have to.

How else are retirees acquiring income while waiting to start Social Security?

The generation that’s retiring now is benefiting from significant inheritance because the Silent Generation [just prior to them] was a big savings generation, and many people have passed on [some] money to their heirs or have died recently and left their heirs some money to live on.

What are your thoughts about the proposed Social Security payroll tax increase for higher earners? This has been debated for years as a way to keep the Social Security Trust fund solvent.

What is very likely to happen is that there’s going to be some adjustments in both the way benefits are paid and the way the system is funded, probably in the form of higher taxes.

The leading [proposal] is to increase the amount of income that’s subject to the payroll tax. Right now it’s capped [at $147,000]. That means a lot of people who earn a very high income don’t pay Social Security tax on more than that first tranche of their money.

There have been a number of proposals to raise that cap so higher-earning people will pay more into the system than they will likely get in the form of benefits down the road.

It’s fairly likely that, particularly for higher-earning households, people will be paying more taxes into the system than they pay today.

How this will be determined and the exact breakpoints will be [decided] by future legislation.

Are there any other proposals besides increasing Social Security taxes for higher earners?

There are a number of levers that policymakers have to adjust the way Social Security is funded and the way benefits are paid that can bring things back in line with the long-term ability to continue to pay benefits and live up to the promise the Social Security system was founded on.

Most likely we’ll see a gradual increase in the full retirement age for future generations as one of those levers.

Please elaborate.

With the exception of the pandemic [deaths], there has generally been a trend to living longer. So I would expect that younger generations — in their 20s, 30s, and 40s — are going to see their full retirement age going up.

They’ll have to wait longer to get the full benefit from the system.


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