Mixing IRA Distributions With Social Security

Many workers save for the future in a 401(k) or another employer sponsored retirement plan. Contributions avoid income tax, and the same is true for investment earnings inside the plan. Often, 401(k) participants roll over the money to a traditional IRA after they retire, which extends the tax deferral.

Many people try to keep their IRAs intact as long as possible, continuing tax free buildup inside the plan.

Example 1: Alice Wells retired at age 62. To make up for her lost earnings, Alice draws down her taxable accounts, so her IRA can keep growing untaxed. Alice’s plan is to wait as long as possible before taking distributions from her IRA. (She’ll have to take at least the required minimum distributions from her traditional IRA after age 70½.)

However, once she retires, Alice finds that she is still short of cash flow. She can start to receive Social Security retirement benefits as early as age 62, so Alice puts in her claim to get the additional monthly income. 

Lower brackets are likely

Alice’s strategy, as described, is followed by many seniors. That is, they take Social Security early and eventually tap their IRA. That may not always be the best approach.

What might indicate taking a different route? Taxes, for one thing. The value of tax deferral depends on your tax bracket. The higher your bracket, the more putting off the IRS makes sense.

Suppose Alice typically was in a 28% or 33% tax bracket during her working years. In 2014, those brackets cover single taxpayers with about $90,000 to $400,000 of taxable income after deductions. Deferring income tax while she worked saved Alice 28 cents or 33 cents on the dollar.

Now that she’s retired, Alice’s taxable income is sharply reduced. In our example, Alice can tap her IRA for cash flow and keep taxable income below $90,000, which would put her in the 25% bracket. At 25 cents on the dollar, tax deferral isn’t as valuable as it was during her working years. On the other hand, taking IRA distributions and paying 25% tax isn’t as painful as it would be in a higher bracket.

Indeed, many retired couples are in the 15% bracket now, which goes up to nearly $75,000 of taxable income, after deductions. Such couples will owe even less tax on IRA distributions.

A plumper pension

There’s another reason to consider reversing the plan to take Social Security early and IRA distributions late. The longer you wait to start Social Security, the larger your monthly benefits will be.

Example 2: Suppose that Alice Wells has an earnings history that would qualify her to receive $2,000 a month at 66, which Social Security considers the “full retirement age” for people now in their 60s. If Alice starts Social Security at age 62, she’ll get only 75% of that benefit: $1,500 a month, plus cost-of-living adjustments (COLAs), for the rest of her life.

On the other hand, Alice can wait as late as age 70 to start Social Security. That would increase the monthly payment from her full retirement age by 32%, from $2,000 to $2,640 a month, plus all the COLAs along the way.

 Not counting COLAs, waiting from 62 to 70 will increase Alice’s annual benefit from $18,000 a year to $31,680 a year, which she’ll receive for the rest of her life.

Once Alice starts to receive Social Security, those much larger payments may reduce the amounts she’ll need from her IRA. If that’s the case, Alice will be substituting Social Security dollars, which are partially taxed under current law, for traditional IRA distributions, which usually are fully taxable.  

    

Building up Social Security benefits might have another appeal for married couples. When the first spouse dies, the survivor will receive the decedent’s Social Security payments, if they are larger than the benefits the survivor had been receiving. Thus, waiting to start Social Security may provide extra cash flow for a surviving spouse.

This plan to tap your IRA early and wait to start Social Security will help some people but not others. Calculations involve each individual’s health and work history as well as some complicated navigation through the tax code. When you are ready to make your decision, our office can help you determine a course of action likely to maximize cash flow and income security as you grow older.