Social Security: Is the Juice Worth the Squeeze?
Social security is a benefit that is widely talked about as individuals reach ages 60+ and begin to prepare for retirement. Clients of ours have asked if social security will be around at all when they retire, what percent of their benefit will be around, and some even want to run financial planning scenarios where they do not count on social security at all.
We cannot predict what amendments will be made to the funding of social security, but there are multiple proposals in congress that relate to how to extend the funding of social security well into the future to provide the full expected social security benefit to all recipients.
Social security is an important factor in planning for retirement. It is an integral part of the financial plan as it comes to what benefits you expect, when you or your spouse start your respective benefits, spousal benefits for non-working spouses, and so much more.
Two key items relating to social security that we wish to focus on today are planning for the taxation of social security benefits, and the effect that this has on your Medicare costs in retirement.
A common misconception is that social security benefits are not taxed when you receive them. They are taxed, to an extent, under the following circumstances:
- Individuals: If your income is between $25,000- $34,000, then up to 50% of your social security benefits will be subject to tax at your income tax rates
- If your income is more than $34,000, then up to 85% of your benefit is subject to taxation at your normal income tax rates
- Married couples: If your income is between $32,000- $44,000, then up to 50% of your social security benefits are subject to tax at your income tax rates
- If your income is more than $44,000, then up to 85% of your benefit is subject to taxation at your normal income tax rates
In all likelihood, retirement expenses for a majority of individuals will land you in the tax bucket where a portion of social security benefits are taxable.
In retirement planning it matters when you start your social security benefit because:
- If you are age 62 to full retirement age, earned income above $19,000 will reduce your current social security benefit that you had been receiving, while also raising your overall tax bill today.
- If you are in full retirement or older, you can receive social security benefits that will not be reduced by earned income, but those social security benefits will still be subject to taxation.
When planning for retirement key considerations are:
- What does your tax picture look like while working?
- What does your tax picture look like when you retire?
- Expected pensions, social security, living expense needs, etc.
- When do you start social security?
- Do you make a strategy for Roth conversions in the years before/after you retire?
Roth conversions are another key player in the planning process. This process takes pre-tax funds and converts them to after tax/Roth funds, with the goal of locking in a lower tax rate at a point in time, compared to the higher tax rates you may well be in in the future. This is not for everyone, and it is done on a case-by-case basis via the financial planning process.
Locking in a lower tax rate on pre-tax funds converted to Roth funds is saving future tax dollars, but it has to be evaluated in conjunction with other factors to see its full benefit. What do we mean by that? If you complete a Roth conversion and are receiving social security benefits at the same time, then reference the bullet points above as to how much of your social security benefit will be taxable. If a Roth conversion moves you from having up to 50% of your social security benefits taxed now to upwards of 85% of your benefits subject to taxation, then more evaluation is needed to see if a Roth conversion is in your best interest.
Also, since Roth conversions raise your income level for the year in which you convert, it is important if you are ages 63-onward, as Medicare starts at age 65. Medicare looks back 2 years at the income someone earns to help set your health insurance premium costs.
In summary, careful coordination is needed when evaluating when to start social security benefits, such as: if you are still working or not when you start social security benefits, whether to initiate Roth conversions or not, what age you are today, how Medicare will be impacted, and how this all impacts your taxation in retirement. An efficient financial plan for retirement taxes this all into account, and it is continually refined to be as tax efficient as possible, while also allowing you to live the lifestyle that you want to live and leave the legacy behind for your loved ones!
Source: https://www.ssa.gov/benefits/retirement/planner/taxes.html
#2: Journal of Financial Service Professionals, article “social security coordination to create a tax-efficient withdrawal strategy” by William Reichenstein and William Meyer. March 2022
Written by: Justin Hamlin, CFP®
These are the opinions of Justin Hamlin and not necessarily those of Cambridge, are for information purposes only, and should not be construed or acted upon as individualized investment advice. Investing involves risk. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bear loss, including total loss of principal. The strategies discussed herein are not designed based on the individual needs of any one specific client or investor. In other words, it is not a customized strategy designed on the specific financial circumstances of the client. However, prior to opening an account, Cambridge will consult with you to determine if your financial objectives are appropriate for investing in the model. You are also provided the opportunity to place reasonable restrictions on the securities held in your account.