Rather than simply maximizing the Social Security benefit, consider maximizing net income after taxes for clients.
By Helen Modly, CFP, CPWA | 01-11-18 | 05:00 AM | Email Article

By Helen Modly, CFP, CPWA, and Barbara Ristow, CFP

The recommendation to delay claiming Social Security benefits until age 70 for a more secure retirement is common, especially if clients are in good health and longevity runs in their families. Obtaining the largest possible spousal benefit, which increases by 8% each year from full retirement age to age 70, is another reason to postpone filing. After all, 8% guaranteed just can't be beat.

Helen Modly, CFP, CPWA, is a wealth advisor with Buckingham Strategic Wealth, a fee-only Registered Investment Advisor. The opinions in this article are the author’s own and may not reflect the opinions of Buckingham Strategic Wealth or Morningstar.com. The author may be reached at nova@bamadvisor.com.

Or can it?

As with all financial decisions, the choice regarding whether to delay receiving Social Security should not and cannot be made in isolation. Depending on a client's individual situation, maximizing total after-tax income can improve long-term results. To understand how, let's look at an example.

Taxation of Benefits vs. Other Income Sources
A financial advisor must look at clients' entire pictures, including their states of residence and current sources of income in retirement. For clients who live in states that don't tax Social Security, it may make sense to claim Social Security benefits as early as age 62, assuming the client is not still working. The average Social Security benefit currently is $1,360 monthly or $16,320 annually. Using these broad averages as an example, let's assume for the sake of argument that 85% of the benefit in question is taxed at the federal level because the client has other income sources. The taxable amount of the benefit thus comes to $13,872. Also assume the client is in the 25% tax bracket, making the federal tax owed $3,468. If the client lives in a state that does not tax Social Security, the total tax due on the $16,320 of benefit income is $3,468. The net amount deposited in the client's checking account is $12,852. (The preceding calculations, as well as the ones that follow, use 2017 tax rates.)

If the same client were instead to withdraw $16,320 from an IRA, he or she would owe federal tax on the full amount at the 25% rate plus any state income tax. In Virginia, where I live, the state income tax rate is 5.75%. Do the math, and the $16,320 withdrawal would net the client $11,302 after taxes. By choosing to take Social Security rather than to withdraw funds from the IRA, the client receives $1,550 more in annual, after-tax income--an increase of 13.7%.

For a client receiving the maximum benefit, $2,639 per month or $31,668 per year, the difference can be even greater, especially if that client is nearing the next higher tax bracket. Again assuming that 85% of the benefit is taxed and a client in the 25% tax bracket lives in a state with no tax on Social Security, he or she would owe federal taxes of $6,729 on a taxable amount of $26,918, resulting in after-tax income of $24,939.

Now let's look at what happens when the client takes the same amount of money from an IRA, assuming the 15% of the withdrawal amount that is now taxed pushes the client over into the 28% bracket. The federal tax is $6,729 ($26,918 taxed at 25%) plus $1,330 ($4,750 taxed at 28%), so federal taxes on the withdrawal of $31,668 are $8,059. If the client lives in Virginia, state taxes amount to $1,821 for a combined tax amount of $9,880. The after-tax amount on the IRA withdrawal is $21,788. In comparison, the Social Security benefit offered additional after-tax income of $3,151, or 14.5% more money.

Claiming Early to Benefit Dependents
Another consideration that may affect whether clients claim early is if they have dependent children who would be eligible for benefits. Children could receive up to half of the retirement benefit, but there is a limit to the amount a family can collect. Nevertheless, for clients who waited to have children and are now 62 or older, it could make sense to claim Social Security benefits early. Children would receive benefits until they turned 18 (unless they were still in high school full-time up to age 19). Unless the child is working, his or her Social Security benefit may not be taxable, so those dollars are even more beneficial. The client is not taxed on their child's benefit.

Let's evaluate how this might work for a family of four where the husband is retired and starts taking his benefit at age 62. The wife is a few years younger and still working. The kids are 14 and 12. Each child would be eligible for half of the father's benefit, which we will assume is the maximum monthly benefit amount. Because only two dependent family members are receiving benefits, their benefits aren't subject to the maximum family rules. On a before-tax basis, the family would receive $63,336 in benefits. The after-tax amount, once again assuming 85% of the benefit is taxed, would come to $56,627 (the children's benefit would not be taxed). To get the same after-tax benefit using an IRA, the client would need to withdraw $81,772, assuming they are in the 25% federal bracket and pay 5.75% in Virginia taxes. This adds $25,145 more to the family's taxable income, probably pushing them into the higher 28% bracket, so in reality, they would likely have to pull even more out of the IRA.

For clients living in states that have high income tax rates, this exercise is even more valuable, especially if the state does not tax Social Security benefits.

States That Tax Social Security
Minnesota, Montana, North Dakota, Vermont, and West Virginia use the same rules as at the federal level, so in these states up to 85% of the benefit is taxed. Colorado allows an exemption of up to $24,000 on Social Security benefits and other retirement income. New Mexico exempts up to $8,000. Utah offers a retirement tax credit but it gets phased out for higher income limits. Nebraska, Kansas, Missouri, and Rhode Island wait to tax benefits until the state adjusted gross income is above a set limit.

Even in states where Social Security is taxed, fewer taxes generally are owed on Social Security benefits than on withdrawals from an IRA. So the next time you are evaluating claiming strategies for a retired client, don't just look at maximizing the Social Security benefit. Also look at maximizing net income after taxes to see if that client might be better off claiming Social Security early.

Securities mentioned in this article



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Helen Modly, CFP, CPWA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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