By: Thomas W. Batterman, CTFA
Selecting an improper IRA distribution strategy for individuals eligible for Social Security benefits can dramatically increase tax liabilities. While you can't control the amount of your Social Security benefits, you can control how much Social Security you elect to pay tax on by careful management of your IRA distributions.
The first step toward a developing a reliable distribution plan is understanding the problem. Once an individual begins receiving Social Security benefits, the tax consequences of those benefits can range from being completely tax free to having 85% of the Social Security benefits received subject to tax. Where a person falls within this taxation spectrum depends upon the determination of what the IRS calls the individual's (or couple's) Modified Adjusted Gross Income, or MAGI.
MAGI determination is a special calculation that adds together most income, whether taxable or tax exempt (but specifically includes otherwise tax-exempt income items such as municipal bond interest) and 50 percent of received Social Security benefits. The relationship of MAGI to certain IRS-mandated levels determines what portion, if any, of Social Security is subject to income taxation.
Since IRA distributions are included in the calculation of MAGI, they can be an important factor in determining how much tax is paid on Social Security income.
However, you can control how much tax you pay on Social Security in many instances by controlling your IRA distribution strategy. If you follow a minimum distribution strategy, which results in ever-increasing required distributions as you get older, you may eventually, and needlessly, lose complete control over the taxability of your Social Security income and lock yourself into paying tax on the largest percentage of Social Security all of the time.
Reviewing your situation
While it is impossible to cover every possible individual scenario in which proper distribution planning could save taxes on Social Security, here are several common situations and the strategies to consider to reduce Social Security taxation:
* If you are taking more than required out of your IRA at present . . .
If you have a smaller IRA and are taking money out of it that you don't really need for living expenses (and if you aren't doing this based upon a previously well planned strategy!), you may be paying needless tax on Social Security benefits that diminish what you are earning. Consider reducing your distributions.
* If you are taking, or plan to take, minimum IRA distributions . . .
Individuals, and especially those with a larger IRAs, should not automatically assume that a minimum distribution strategy is the best plan. Project your IRA distributions based upon your distribution election and your projected IRA growth. Consider these ideas:
- Don't wait until age 70 to begin withdrawing.
Instead, consider taking distributions immediately after you retire and before you reach age 70 1/2. By taking money out of your IRA during your post-59 and pre-70 years, you can dramatically reduce the amount of IRA distributions you will be required to take out later in life.
On the other hand, you should be careful not to withdraw too much and incur needless tax on Social Security during this period. If you are fortunate enough to be able to retire without needing to be eligible for Social Security right away, this window prior to Social Security eligibility can provide an excellent opportunity to take money out of an IRA without current concern about the Social Security tax.
Carefully controlling distributions early can keep your taxes down while keeping you in control of Social Security taxation later.
- Review your investment strategy.
You also can review your investments and how they impact the growth of your IRA. Under previous laws and/or while you were working, it may have been best to have your retirement investments (such as IRAs) more heavily weighted toward rapidly growing investments (such as stocks). However, rapid growth of your IRA after retirement simply increases the amount you will need to withdraw from your IRA later, which may well increase your income taxes and perhaps expose you to the Social Security "Supertax."
Also bear in mind that stock value growth in an IRA may be relatively disadvantageous in today's tax environment. Such value growth in your IRA will ultimately be taxed at ordinary income tax rates. Alternatively, this same value growth in these same investments outside your IRA will be subject to a maximum capital gain tax of 20% under current law and may ultimately be completely tax-free on your death.
If your investment objective and financial resources permit, consider changing your investment allocations to invest in slowly growing assets inside your IRA and invest in rapidly growing stock investments outside your IRA. This will slow down the growth of your IRA and the ultimate tax and Social Security Supertax exposures on it while providing you with an overall portfolio growth consistent with your goals at a lower tax rate.
- Consider Annuitizing your distribution.
An annuitized approach would result in you withdrawing about the same amount each year. You do not have to have an annuity investment to take advantage of an annuitization--or a flat rate--distribution strategy that will help your situation. You could save a substantial amount in taxes if the flat rate can be set to keep your income below or in the lower levels of Social Security taxation while expiring your IRA over your estimated life expectancy.
Such a strategy can be effective both before and at the time you reach age 70.
- Consider taking large distributions in your first few years.
While this strategy is particularly worthy of consideration to reduce the size of future IRA distributions in years prior to the owner's receipt of Social Security income, it can also be helpful for individuals who are "trapped" into paying escalating taxes on their IRA and Social Security benefits because they inadvisably pursued a minimum distribution strategy earlier.
In the right situations, taking a large amount out of the IRA in a couple of years after you reach age 70 can put you back in control of your tax situation and allow you to save significant tax amounts you otherwise would pay by pursuing a minimum distribution strategy for the rest of your life.
While this strategy will increase your tax in the years of the larger distributions, and may even cause you to pay tax on Social Security at 85 percent in those years, it may be advisable to take that short term pain to regain control of your future tax situation and save yourself substantial tax dollars in the long run.
Tailored analysis required
Unfortunately, it's difficult to provide generalized guidelines, since each individual's financial circumstances and objectives are different. Discussing examples of problem situations and ideas about how they might be resolved suggests the importance of doing your own analysis to determine what course of action is best for your unique financial circumstances.
It is clear, however, that the standard "wait until you are 70 and then take out the minimum amount" answer is not always the lowest-tax approach.
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Thomas W. Batterman, Certified Trust and Financial Adviser and Senior Relationship Manager for Vigil Trust & Financial Advocacy, Wausau, WI, has 17 years of experience in the financial advisory field. He is a licensed attorney and is a member of the National Association of Personal Financial Advisors. His firm, Vigil Trust & Financial Advocacy, was started in 1988 as the State of Wisconsin's only Fee-Only registered investment adviser with full corporate trust capabilities and is a founding member of the Association of Independent Trust Companies.