Retirement 2.0blog

Retirement income hit with highest effective tax rates

New software helps advisers maximize spendable income for clients

Feb 1, 2016 @ 12:19 pm

By Mary Beth Franklin

Here's a shocking statement: Some Social Security recipients are subject to the highest marginal income tax rates in the country — topping 55% in some cases — depending on their other sources of retirement income in a given year. What's even more shocking? It's true.

Most advisers think of income taxes in terms of the federal tax brackets: 10%, 15%, 25%, 28%, 33%, 35% and 39.6%.

But in the retirement space, taxes are different, particularly once clients turn 70 and must start taking annual required distributions from their retirement accounts. Their effective marginal tax rate — the rate at which one additional dollar of income will be taxed when added to existing income — can be higher than the highest tax bracket.

Consider this example supplied by Social Security Timing, a software program for financial advisers to help their clients maximize their Social Security benefits: A married couple who is subject to required minimum distributions, has combined Social Security income of $50,000 per year, plus $15,000 in net long-term capital gains and $25,000 in IRA distributions.

Because of the higher standard deduction for the elderly plus two personal exemptions, the couple is in the 15% federal tax bracket, and will pay 0% on their long-term capital gains.

Then assume they need an additional $1,000 beyond their normal spending needs and decide to tap their IRA for the extra cash.

In their 15% federal tax bracket, you would expect that a $1,000 IRA withdrawal would cost them $150 in federal income taxes. You would be wrong.

That extra $1,000 IRA withdrawal will also drag 85% of an equivalent amount of Social Security benefits onto their tax return. The result: $850 of Social Security benefits will be taxed at 15%, adding another $127.50 to their tax bill ($1,000 x 0.85 = $850 x 0.15).

The combined ordinary income and additional Social Security income pushes the $1,850 of long-term capital gains into taxable status. That additional tax of $277.50 on their long-term capital gains brings the total tax on their $1,000 IRA withdrawal to $550 — a 55% effective marginal tax rate.

A wise adviser who could foresee future spikes in marginal tax rates may be able to create tax-saving opportunities, said David Cechanowicz, director of education for Social Security Timing. The sweet spot for planning is generally between the ages of 66 and 70 if your client has retired, is willing to delay claiming Social Security and is not yet subject to minimal withdrawal requirements from his or her retirement accounts.

“During that four-year period, you could either start doing Roth IRA conversions or harvesting IRA money,” Mr. Cechanowicz said. Taking a tax hit in one year can minimize taxes in subsequent years and reduce future RMDs.

“By delaying Social Security and changing the blend of income, I have seen 90% reductions in taxes,” he added. “It can be quite magical if you structure it well, particularly for middle-income clients.”

Of course, figuring out how to do that is a challenge. “The Bipartisan Budget Act of 2015 eliminated and is phasing out some Social Security claiming strategies that would have provided additional income to clients,” Mr. Cechanowicz said.

Social Security Timing is now offering a new “Tax Clarity” program that aims to help replace lost income by finding additional net household income. The company is offering a 10-day free trial of the program and a discounted annual fee through April 15.

Although Social Security Timing may be the latest software provider to look beyond the value of maximizing Social Security benefits to coordinate the overall tax efficiency of retirement income, it's not the only one.

A few months ago I wrote about Impact Technology's Cash Flow Decision program. It considers which claiming strategies will maximize Social Security benefits over a client's lifetime and also takes into account how clients' other income and assets could affect how much of their Social Security benefits are taxed.

Another Social Security claiming strategy pioneer William Meyer, founder of Social Security Solutions, and his research partner William Reichenstein, Powers professor of investment at Baylor University, first discussed the impact of this high marginal tax rate, which they dubbed the “tax torpedo,” and its effect on portfolio longevity several years ago. Last year, Social Security Solutions created a coordinated Social Security and tax-efficient retirement income drawdown program based on their research.

Figuring out how to help your clients keep more money in retirement is a great way to satisfy existing clients and attract new ones.

Mary Beth Franklin is a contributing editor to arjuna-design and a certified financial planner.

The ninth paragraph of this story has been updated to indicate that the combined ordinary income and additional Social Security income will push long-term capital gains, not qualified dividends, into taxable status.

0
Comments

What do you think?

View comments

Recommended for you

Sponsored financial news

Upcoming Event

Mar 13

Conference

WOMEN to WATCH

arjuna-design is honoring female financial advisers and industry executives who are distinguished leaders at their firms. These women have advanced the business of providing advice through their passion, creativity, inclusive approach and... Learn more

Deputy editor Bob Hordt and senior columnist Bruce Kelly discuss the reasons for the marked shift of advisers between channels, including technology, the DOL fiduciary rule and the broker protocol.

Recommended Video

Channels

Latest news & opinion

Morgan Stanley said to be trimming 600 funds from platform

While not confirming the number of funds on the chopping block, the firm acknowledged it is culling its offerings.

As tax season gets underway, clients are looking ahead to how tax bill will affect 2018 returns

Advisers can put strategies in place now to make sure that there will be no hidden surprises this time next year.

Independent broker-dealers are stepping up their game on recruiting from the wirehouses

Independent broker-dealers have narrowed the gap between themselves and the wirehouses and are able to attract more quality brokers from the Big Four.

Capital Group, sponsor of American Funds, wins 401(k) lawsuit

Decision comes as financial services companies, especially those focused on active management, have been sued for self-dealing.

SEC considers barring aggrieved investors from suing companies

Swept up by pro-business zeitgeist, regulator seeks to reverse two-decade slump in U.S. stock listings.

X

Hi! Glad you're here and we hope you like all the great work we do here at arjuna-design. But what we do is expensive and is funded in part by our sponsors. So won't you show our sponsors a little love by whitelisting arjuna-design.com? It'll help us continue to serve you.

Yes, show me how to whitelist arjuna-design.com

Ad blocker detected. Please whitelist us or give premium a try.

X

Subscribe and Save 60%

Last News

t rowe price retirement 2030 deadline for sep ira contributions how to get cfp designation jhpensions funds how to enroll in medicare part b vanguard index s&p 500 social security spousal benefits early retirement lipper fund ratings rollover ira first time home buyer social security death benefits for surviving children tcw large cap growth loomis sayles bond fund retail class maximum amount to contribute to ira wells fargo bank in knoxville tennessee wolf of wall street cold call script bny mellon asset servicing pittsburgh pa how much is ronnie lott worth van eck global hard assets fund stock wash sale rules capital gains jp morgan financial advisor training program deduction for interest on home loan can you file taxes if you get ssi how much does a financial professional associate make at prudential baby boomers generation x millennials how much does a ferrari f50 cost ira minimum distribution requirement excess contribution to roth ira morgan stanley garden city ny how much tax is withheld from social security benefits i bought turbotax last year fidelity 529 college savings plan fidelity 401k index funds highest performing small-cap fund five-year minimum