How to minimize taxes when Social Security, RMDs kick in

Today, more retirees understand the value of maximizing their Social Security benefits by delaying collection up to as late as age 70. This sudden increase in retirement income, and potentially even greater amounts at age 72 when required minimum distributions (RMDs) begin, can trigger higher taxes that retirees may not have anticipated. As an advisor, how do you help your clients plan for this tax increase/? 

Start by maximizing Social Security income  

Many retirees know that the later they file for Social Security, up to age 70, the higher their benefits. Most workers with retirement accounts, such as IRAs, SEPs, 401(k)s, 403(b)s and other defined contribution plans, also realize that they must start withdrawing funds from these accounts by age 72.

What they may be missing, though, is the need for managing the sequence and amounts of withdrawals from their retirement and personal investment accounts with a focus on the tax consequences, including taxation of their Social Security income.

Although Social Security income is taxable, not all Americans will be affected by or have the ability to manage this taxation. Those whose only or major source of retirement income is Social Security will fall below the minimum taxation thresholds. 

On the other end, those with substantial retirement income and assets will be above the upper taxation thresholds, and 85% of their Social Security will be taxed. For those in the middle, however, the opportunity to manage specific income streams and account withdrawals can have an effect on their tax liability during their retirement years.

Along with the decision of when to claim Social Security benefits in their late 50s, the timing of withdrawals from taxable retirement accounts can be considered as early as age 59 ½, when withdrawals from these accounts are allowed to begin. 

For retirees hoping to start collecting Social Security at full retirement age or later, drawing down fully taxable retirement account balances prior to age 72 can be used to bridge the income gap in the intervening years. 

The resulting tax advantage from lower retirement account balances when RMDs begin is to lower adjusted gross income (AGI) and therefore taxation. The retiree’s larger Social Security income, due to waiting to collect, is given a tax advantage since only 50% of it is used in the taxation calculations.

The effect of RMDs

The IRS has very specific rules about RMDs, and retirees cannot keep retirement funds in their accounts indefinitely. 

RMDs are the minimum amount retirees must withdraw from their employer sponsored retirement accounts, traditional IRAs, and IRA-based plans such as SEPs, SARSEPs and SIMPLE IRAs each year. Roth IRAs do not have required withdrawals until after the death of the owner. 

Starting in 2020 with passage of the SECURE Act, withdrawals from these accounts must start no later than age 72. The exact date that distributions are required to begin is April 1 of the year following the calendar year in which the retiree reaches age 72 or retires in some cases. 

For a certain segment of retirees, RMDs can be a major consideration and source of increasing the combined income that is used to determine Social Security income taxation.

Many people do not realize they should include the amount and timing of these distributions in their retirement planning or how the additional AGI from these withdrawals can cause their taxes, including those on their Social Security income, to increase. 

Except for withdrawals that are received tax-free, such as from designated Roth accounts, the withdrawals will be included in taxable income. 

Although RMDs may not be a major factor in the Social Security claiming decision, every year more retirees are subject to taxation of their Social Security income and should be aware of this issue.

Options for managing taxation

Evaluation and possible repositioning of assets prior to retirement can also directly affect future taxable income based on whether withdrawals are coming from income-producing or growth-oriented accounts.

There are several management techniques financial advisors can offer retirees when creating a retirement financial plan that manages taxation, including that of Social Security income. Lowering AGI, and resulting taxation, in certain years is the goal to create the most consistent, highest standard of living throughout retirement.

A shift of taxable account investments from income funds to growth funds will lower AGI. Shifting securities and investments from high-yield interest generating funds to lower income generating growth investments can achieve the same purpose. 

Funds may be shifted toward tax-deferred and/or tax-preferred accounts or other financial products, such as funding 401(k), 403(b) or 457 accounts. Finally, converting regular IRAs into Roth IRAs may result in taxable income up front, but those nontaxable Roth IRA withdrawals in the future can maintain a lower taxable income.

Of course, financial products, when sold, may generate elevated levels of AGI and therefore taxation in the years those gains are realized. 

As noted above, prioritizing and sequencing account withdrawals is the final step in managing income tax. By analyzing Social Security claiming and fund withdrawal sequence, the impact on net after-tax income and standard of living in retirement can be quantified.

The value of retirement planning

A 2014 MassMutual study found that the happiest retirees say they took specific steps to plan early, preferably more than five years out. Those concrete steps include calculating the best time to start collecting Social Security, saving more, creating a budget, and working with a financial advisor. According to the study’s findings, 58% of the most satisfied retirees had worked with a financial advisor prior to retirement.

Financial advisors who have Social Security expertise and the understanding of tax consequences when withdrawing funds from retirement accounts and other income streams are extremely well-suited to providing retirement planning. 

By offering comprehensive retirement financial planning, financial advisors have the opportunity to help clients manage their income tax, increase their standard of living, extend the longevity of their portfolios, and leave a larger legacy.

Martha Shedden, RSSA, CRPC, is the president and co-founder of the National Association of Registered Social Security Analysts (NARSSA) in which she leads the development of the education and training program for all Registered Social Security Analysts (RSSAs). Follow Martha and NARSSA on LinkedIn.