There are a boundless number of scenarios to consider while saving up for retirement. But what is your plan for when you finally do decide to retire? Often times, people neglect to consider all tax implications when planning for retirement. Failing to realize how much to withdraw or from what accounts can be detrimental to even the most prudent of investors. One factor in helping you keep more is controlling the “Tax Torpedo”.
So what is this so-called “Tax Torpedo”? The Social Security Tax Torpedo occurs when an individual level of retirement income from other sources, prompts a percentage of the Social Security to be taxed, increasing an individual’s marginal tax rate. When an individual’s income reaches $25,000 on a single or $32,000 on a jointly filed return, up to 50% is taxable. When it exceeds $34,000 and $44,000, respectively, a staggering 85% is subject to taxation. Also, bear in mind your rising cost of living adjustments each year will lead to more taxable Social Security benefits.
When aiming to decrease your tax burden, it is important to consider which assets to withdraw from. Those planning to collect Social Security benefits upon retirement must take into consideration what, if any, assets will put them over the Tax Torpedo income threshold. Some assets, like traditional IRAs and dividends, are taxable upon withdrawal and are included in your gross income. This gross income, subject to federal income tax, combined with Social Security benefits tax may result in a Tax Torpedo. Remember that at the age of 70 1/2, tax rules require owners of IRAs and other retirement accounts to begin making minimum distributions, which will count towards gross income.
In planning for retirement, eligible individuals might consider contributing money into a Roth IRA, which is not subject to taxes upon withdrawal and also offers estate tax benefits. However, if you’re converting from a pre-tax retirement account, remember to convert to a Roth prior to collecting Social Security benefits, as income generated from the conversion becomes taxable after collecting.
Another method to avoid the Tax Torpedo is delaying Social Security benefits. I know, after all the years spent saving and prudently investing for the future, the last thing any retiree wants to hear is “wait a few more years for your benefits”. But planning and finding your optimal age to start collecting could lead to minimizing the brunt impact of the Tax Torpedo and greater portfolio longevity. Use this time to withdraw from IRA’s, 401k’s and other self-directed plans to generate the retirement income needed. This will reduce the asset balance subject to taxes in later years and could lower your overall tax bill. Delaying Social Security benefits may not only lower your tax burden but will also result in larger Social Security benefits in the future. Every year after retirement, your Social Security benefits will increase by 8% up until the age of 70. However, be sure you consider the longevity of your retirement portfolio in order to avoid drawing down too much.
If you choose to begin collecting Social Security benefits early there are many scenarios to consider. Remember that, collecting at the age of 62 would mean a reduction in benefits but more checks for a longer time. As in the prior scenario, draw down from your retirement accounts while staying under the threshold. Be sure to invest excess funds tax-wise and prudently. With a favorable life expectancy, collecting early and investing may lead to a bigger pay out than if you had waited to collect at full retirement age.
So many factors go into deciding when to take Social Security benefits, including other assets, desired retirement dates (early, normal or late), health and life expectancies and how you’d like to spend your time. But, by planning ahead you can work to avoid paying unnecessary taxes. Allow yourself to explore newfound freedoms in your retirement, and keep as much of your earnings as you can by avoiding the Tax Torpedo when you can. And, if this task seems complicated meet with your financial advisor to discuss the tax implications of your retirement income.