The last two posts, Say Goodbye to Up to 30% of Your Social Security Benefits – Parts 1 and 2 discussed taxation of Social Security benefits. As explained in both posts, up to 50% or 85% of Social Security benefits can be taxable depending upon the amount of one’s “combined income” (50% of Social Security benefits plus adjusted gross income increased by tax-exempt income) compared to specified thresholds that are dependent upon one’s tax filing status (i.e., single, head of household, married filing separate, or married filing joint) and one’s tax rates.
Although, as pointed out in last week’s post, taxation of Social Security benefits has been a thorn in Congress’ side ever since it came into being in 1984, it appears that it’s here to stay. Income taxation of Social Security benefits can be reduced or, in some cases, eliminated, in one or more years with proper planning. While much of the planning is ongoing throughout the years that one is collecting benefits, there are several opportunities that should be analyzed and potentially implemented beginning in one’s 40’s, many years before the receipt of one’s first Social Security check. This post focuses on pre-benefit receipt planning and Parts 2, 3, and 4 address planning strategies during the Social Security benefit receipt years.
Before discussing strategies that can be implemented to reduce taxation of Social Security benefits, let me make clear one strategy that generally isn’t effective. Although it hasn’t been given as much attention the last several years in our low-interest rate environment, income tax and investment planning strategies often include an analysis of after-tax return returns from taxable vs. tax-exempt investments. As mentioned in the previous two posts as well as the beginning of this one, “combined income,” which is the starting point for calculating taxable Social Security benefits, is increased by tax-exempt income. As a result, assuming that your goal is to reduce taxable Social Security benefits, other than the fact that the amount of income from a tax-exempt investment is generally less than the income from a similar taxable investment, inclusion of tax-exempt investments as part of your investment portfolio won’t be of much benefit to you.
Perhaps one of the greatest opportunities for reducing taxable Social Security benefits and ongoing associated taxation of same that can be implemented beginning 20 or more years before the receipt of one’s first Social Security check is a Roth IRA conversion or series of conversions over several years. This strategy was featured in the March 15, 2010 post, Want to Reduce Taxable Social Security Benefits? Consider a Roth IRA Conversion as part of Retirement Income Visions™ extensive Roth IRA conversion series.
As discussed in that post, to the extent that a Roth IRA conversion reduces the amount remaining in your traditional IRA, your required minimum distributions (“RMD’s”) that you must take from your traditional IRA’s beginning when you turn 70-1/2 will be reduced. Reduced RMD’s result in less “combined income” which can reduce the amount of taxable Social Security benefits and can also reduce the marginal tax rate that is applied to the taxable portion of your benefits, resulting in less taxes. It’s important to keep in mind that this strategy, in order to be effective, needs to be implemented before receipt of Social Security benefits. To the extent that it is executed while one is receiving benefits, it will generally increase taxable income and taxation of benefits.
Another strategy than can be implemented well before receipt of Social Security is investment in one or more non-qualified (i.e., not within an IRA or other retirement plan) deferred income annuities, or “DIAs”. For an introduction to this powerful retirement income planning investment strategy, please refer to the November 23, 2009 post, Deferred Income Annuities: The Sizzle in a Retirement Income Plan. When structured as a nonqualified annuity, there are two potential ways that DIAs can be used to reduce taxation of Social Security benefits. First, the payout start and end dates from one or more DIAs can be selected to plan for the amount of income that will be paid out to reduce taxation of Social Security benefits. Secondly, a portion, sometimes very sizeable, of DIA payouts from nonqualified investments are tax-favored since they aren’t subject to income taxation by virtue of an “exclusion ratio.” Furthermore, unlike tax-exempt investment income, the portion that is excluded isn’t added back to “combined income” when calculating taxable Social Security benefits.
Permanent life insurance is another strategy that can be implemented many years before receipt of Social Security retirement benefits to reduce taxation of those benefits. To the extent that there is build-up of cash value within whole life, universal life, or variable universal life insurance policies, this cash value, when not subject to modified endowment contract, or “MEC,” taxation rules, can be distributed either through loans and/or withdrawals during one’s retirement years, often with little or no associated income taxation. To the extent that this is achieved, this will favorably affect taxation of Social Security benefits.
When you get into your later 50’s and get closer to the earliest potential start date for receipt of your Social Security benefits, i.e., age 62, a key Social Security tax-reduction strategy that has been discussed extensively in several of the Social Security posts beginning with the October 4, 2010 post, Plan for the Frays in Your Social Security Blanket – Part 2 of 2, is the choice of benefit start date for you and your spouse if married. While a delay in start date can result in increased total benefits received during one’s lifetime, it will also result in delay of taxation of benefits as well as potential increased after-tax benefits once commencement of benefits occurs.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.