We reviewed last week the methodology used to calculate the amount of one’s Social Security benefit, but another important aspect of Social Security planning is the income taxes that will be due on those benefits.
First, some historical perspective. From the establishment of the Social Security Administration in 1937 until 1984, benefits were income tax free. During the Reagan administration, up to one-half of Social Security benefits became taxable. This change was part of a broader package designed to raise revenue and cut long-term costs for the Social Security program.
In 1993, the Clinton Administration added a second tier, allowing up to 85% of a beneficiary's Social Security income to be exposed to federal income tax.
Here is an example of how the tax is levied: Jack and Jane have a combined Social Security annual benefit of $36,000. Their other income totals $24,000. One half their benefit + their other income is $18,000+$24,000=$42,000. As a result, 50% of their Social Security benefits would be taxable. For single filers, the threshold is $25,000 instead of $32,000. The more combined income you have, the larger is the tax on Social Security benefits.
Here is the rub, the income thresholds associated with the taxation of benefits have not been adjusted for inflation once in the past 35 years. According to The Senior Citizens League, a tax that had once affected around 10% of households now impacts 56%, with this figure expected to move higher as time passes.
The federal government faces a conundrum: if they remove the tax on Social Security, the projected deficits in the system would get worse. Consider that In 2016, the taxation of benefits was responsible for $32.8 billion (3.4%) of collected revenue. Without this channel of revenue, Social Security's asset reserves would likely deplete even faster.
Since the income taxation of Social Security benefits is not going away, the best that one can do is to mitigate the tax bite by engaging in some pre-retirement planning.
Here is an example: we know that delaying receipt of one’s Social Security benefit beyond full retirement age increases those benefits by 8% each year or ⅔% each month. If I reach my full retirement age in 2019 and my PIA is $3,000 per month, I can delay receipt of my benefits until age 70. My benefit at that time will be 46 months X ⅔% =131% greater or $3,930. At my age 70, if I had no other income and filed as a single, my Social Security benefit would be tax free.
As a result, it may be advantageous to withdraw monies from other accounts in the period between full retirement age and age 70 and delay receiving Social Security benefits as long as possible. In this way, more retirement income will be tax free.
Another little-known option for persons who delay receipt of the Social Security benefit is the availability of a lump sum option.
Assume that Bob is about to commence receipt of his benefits at his age 70. He has the option to take six months of the benefits he would have received at age 69½ . So, if Bob was scheduled to receive $4,100 per month at 70, he could elect instead to take a lump sum payment of $23,616.
That election has a price tag, however. Bob’s lifetime benefits would be reduced to $3,936 per month, or 4% less. And when Bob passes, his spouse would have forfeited the higher benefit.
The reason to make such an election might be medical bills or some other emergency need, so this option should not be made cavalierly.