Minimizing the Bite
There isn’t much you can do to minimize taxation of Social Security–and most experts don’t consider it important enough to drive overall retirement-plan strategies. “Most of the people we work with understand it–they would prefer not to pay it, but it is what it is,” says Rosica. “Some planning can be done around it, but it can be challenging because planning for this might cause other things not to work as well.”
Still, the taxation of benefits has the effect of boosting marginal tax rates–significantly in some cases. A beneficiary otherwise in a 15% tax bracket could face marginal rates of 22.5% to 27.75%, calculates Kitces; those in the 25% bracket could see marginal tax rates as high as 46.25%. “It just makes your tax bracket higher than you might have otherwise thought,” he says.
The bracket-boosting effect kicks in while Social Security taxes are phasing in–starting at $25,000; after the maximum amount of Social Security (85%) has been included in income, the rates start behaving normally again. Managing the timing on drawing income from tax-deferred accounts can help, Kitces says. “When do I take money out? Am I doing a Roth conversion? Do I want to invest in a nonqualified deferred annuity as a way to defer income?”
The Roth calculations, in particular, change when Social Security tax is considered, he says. “The classic rule is to put an available dollar into an IRA when you still are working, if you think your tax bracket will be lower in retirement,” he says. “But if I’m in a 15% bracket and it’s actually going to be over 27% in retirement, I should pay my tax bill now and fund the Roth.”
An every-other-year strategy for taking tax-deferred income also can help, says Rosica. “If I’m in that $25,000 to $50,000 income level, there probably are ways to arrange your affairs to get better outcomes,” he says.
Kitces adds that, in some cases, the best alternating-year strategy is to add more income in the high-income year, after the 85% cap has been hit, to avoid falling in the $25,000 to $50,000 range in the following year.
“This is somewhat counterintuitive for most people, but it’s actually a big opportunity,” he says. “For instance, rather than having annual income of $50,000, you really might be better off by doing $75,000 in one year, then $25,000 the following year. Most people are trained to think that boosting income to $75,000 is ‘higher’ income and causes more taxes when, in reality, it can result in less!”