A delayed Social Security filing can boost your monthly benefit income substantially. But did you know that a smart Social Security strategy also can boost the longevity of your portfolio?
My July column for Morningstar.com looked at an array of resources that can help individuals and couples optimize their benefits. That sparked a comment thread among Morningstar.com readers about the relationship between Social Security filing and portfolio longevity, with much of the discussion focused on an important 2012 article on the subject in the Journal of Financial Planning by William Reichenstein, a professor at Baylor University who has written extensively on Social Security planning, and William Meyer, a financial-services industry veteran.
Reichenstein and Meyer are the co-founders of SocialSecuritySolutions.com, one of the fee-based Social Security maximization services that I discussed in the July column. Their article concluded that a delayed filing–and using assets from your portfolio to fund living expenses in the early years of retirement–is an effective way to “buy” additional annuity income in the later years. And the increased annuity income lightens pressure on portfolios to such a great extent that portfolio life can be extended substantially. They concluded that portfolios ranging from $200,000 to $700,000 enjoyed the greatest life extension–anywhere from two to 10 years longer. The strategy works best for mass-affluent clients because Social Security represents a larger proportion of total net worth than it does for wealthier households.
I touched base recently with Reichenstein and Meyer to get their latest thinking on the subject. It turns out they’ve updated their research to look at an additional question: What happens to portfolio longevity when Social Security filing strategies are combined with tax-efficient withdrawal strategies?
What follows is an edited transcript of our conversation. Reichenstein and Meyer also have created a more detailed case study especially for Morningstar.com readers, which can be downloaded at no charge here as a PDF. You can also analyze your own numbers using a free online tool that SocialSecuritySolutions.com has created.
Q: Can you walk us through the basics of how delayed Social Security filing can extend portfolio life?
Bill Meyer: When people come in our door, many say they plan to file for Social Security when they turn 62, even though that’s most often not the best decision. Most of us have a behavioral bias to take Social Security right away, and people don’t really think about it as an asset. But it’s actually the largest asset most people have. Delaying your filing and winnowing down your savings to make up the shortfall in the early years of retirement makes a lot of sense.
Most financial plans use a 30-year life horizon from retirement. If your life is substantially shorter, you may do better filing earlier because the break-even point usually is around 80 years of age.
Bill Reichenstein: But this isn’t just about whether you live beyond 80. People are very concerned about not running out of money during their lifetimes.
Q: Perhaps people are starting to get the message about how delayed filing can have a direct impact on lifetime Social Security income. But I think many would be surprised to see how this can affect portfolio longevity. How does that work?
Reichenstein: Let’s take the example of an individual who is going to need to spend $36,850 in aftertax dollars in her first year of retirement, and that we’re going to adjust that for inflation every year thereafter. For illustration purposes, we’ve set that spending number at a spot so that the portfolio could last 30 years with a tax-efficient withdrawal strategy.
Let’s also assume she has $500,000 in financial assets, including $400,000 in a 401(k) or some other tax-deferred account, and $100,000 in a taxable account. We’ve added more of the assumptions in the accompanying PDF.
Finally, we’re assuming that her Primary Insurance Amount, or PIA, from Social Security is $1,500–that is, the monthly payment she’d be entitled to if she files for benefits at her full retirement age of 66.
The chart shows the impact on portfolio longevity assuming she retires at 62, but files for benefits at age 62, 66, and 70.
Q: Why did delaying Social Security benefits allow the portfolio to last longer?
Reichenstein: There are two reasons delaying Social Security would allow the portfolio to last 10-plus years longer. First, assuming this 30-year lifespan, delaying Social Security benefits from 62 to 70 would increase the purchasing power of lifetime Social Security benefits by $117,720. It is like she has an additional $117,720 of retirement assets.
Second, by delaying Social Security benefits until 70, she would reduce the portion of benefits that are taxable. After 70, she would receive a relatively large Social Security benefit and need relatively little from the 401(k). Because of the formula used to determine the taxable portion of Social Security benefits, this would cause less Social Security benefits to be taxable.
Q: Let’s explore that a bit further–the question of a tax-efficient withdrawal strategy and how it can add longevity to the portfolio. Before we get to the results, give us your thoughts on how retirees should think about constructing a tax-efficient approach to Social Security and portfolio drawdowns.
Meyer: What you want to do is avoid the so-called tax torpedo, which is the rise–and then fall–in marginal tax rates that can be caused by taxation of Social Security benefits. A single individual will owe federal income tax on part of her Social Security benefits if her adjusted gross income (including tax-exempt interest), plus half of her Social Security benefits, add up to $25,000 or more. This threshold is $32,000 for joint filers. Taxes are never levied on any more than 85% of your benefits.
This year, the 15% bracket for married couples filing jointly applies to taxable income between $17,851 and $72,500. For an individual, the range is $8,926 to $36,250.
Q: What are the implications there for Social Security and a withdrawal strategy?
Reichenstein: Many planners would suggest that this retiree draw down her taxable assets first and then her 401(k). But it makes sense for her to withdraw some money from her 401(k) each year as long as those withdrawals would be taxed at a low rate and then withdraw additional funds from her taxable account. If she doesn’t do that, she would miss the opportunity to convert some of her pretax dollars in her 401(k) to aftertax dollars at low tax rates.
The chart below shows the results from two withdrawal strategies. In the Less Tax-Efficient Withdrawal Strategy, she follows the traditional advice and withdraws funds each year from her taxable account to meet her spending needs until that account is exhausted. Then she withdraws all funds from her 401(k) to meet her spending needs. In the first few years, her taxable income would be zero. She would have some unearned income from the remaining assets held in her taxable account, but this income would be less than the sum of her personal exemption and standard deduction. Therefore, she could withdraw some funds that would be taxed at 0%. Moreover, she should withdraw additional funds that would be taxed at 10%. She should not miss the opportunity to convert pretax dollars in her 401(k) to aftertax dollars at these low tax rates
The second strategy is the Tax-Efficient Withdrawal Strategy. In this strategy, she withdraws sufficient funds from her 401(k) each year as long as these withdrawals would not be taxed at a marginal tax rate exceeding 15%. A key insight is that the government takes a portion of her 401(k) distributions. In the latter strategy, she times these withdrawals to minimize governmental taxes during her lifetime. The additional portfolio longevity of the Tax-Efficient Withdrawal Strategy compared with the Less Tax-Efficient Strategy is attributable to her timing 401(k) withdrawals to take advantage of marginal tax rates, where these marginal tax rates reflect tax brackets adjusted to reflect the taxation of Social Security benefits. (Of course, this strategy–like any other drawdown plan–should take into account the rules for Required Minimum Distributions).
Q: This sounds complicated. What advice do you give to readers?
Meyer: Coordinating a Social Security claiming strategy with a withdrawal strategy is complicated. You have to run your numbers. Work with an advisor who specializes in Social Security, taxes, and drawdown strategies. We have created a free report that allows a person to see the extra money she can find by maximizing Social Security and implementing a smart income strategy. The personalized report calculates the added longevity and assets someone can find by focusing on these three areas, and it can be a good place to start.