Keep a Low Profile
by David Freitag, CLU, ChFC, CRPCMr. Freitag, CLU, ChFC, CRPC is affiliated with Impact Technologies in Charlotte, NC. Connect with him by e-mail: [email protected]
One thing that makes Social Security retirement benefits different and a special part of anyone’s retirement plan is taxes, but they not taxed like regular income from most other sources in retirement. Although Social Security benefits are “tax-preferenced,” they are often not totally tax-free. The key to keeping some, or all, Social Security benefits out of the reach of Uncle Sam requires some pre-planning and balance.
So how does this all work? Here’s a high-level, step-by-step guide to help estimate the amount of tax that’s due on Social Security benefits:
Determine the amount of “Provisional Income” available this year. By IRS definition, “Provisional Income” includes 100% of the earnings from work, pension plan payments, dividends and interest from regular investments, withdrawals from IRA and 401(k) plans and interest from municipal bonds. Next, you must add 50% of the Social Security benefits paid in the year. Since only 50% of the Social Security benefits are added into the “Provisional Income” formula, the payments are indeed “tax-preferenced.” Although it’s very important to recognize the components of the “Provisional Income” formula, it is equally important to recognize what’s missing from this definition: distributions from Roth IRAs and most withdrawals from cash-value life insurance policies.
Apply a qualification formula to the “Provisional Income” amount. This is different for a single taxpayer or Head-of-Household from those married couples filing a joint return. For singles or Head-of-Households, if the “Provisional Income” is below $25,000, Social Security benefits are not reported as income. When “Provisional Income” ranges between $25,000 and $34,000, up to 50% of the benefits are taxable. When “Provisional Income” is above $34,000, up to 85% of the Social Security benefits must be reported as income.
The formula is a little more forgiving for a married couple filing jointly. For married couples filing a joint return, if “Provisional Income” is below $32,000, Social Security benefits are not reported as income. When “Provisional Income” ranges between $32,000 and $44,000, up to 50% of the benefits must be reported. When “Provisional Income” is above $44,000, up to 85% of the Social Security benefits are reported as income.
Let’s apply these rules to a married couple. Assume that Bob and Mary recently retired and started taking their Social Security benefits. At the end of the year, they have $12,000 of income from municipal bonds, traditional IRA distributions of $26,000 and Social Security benefits of $5,000.
This is a good news/bad news example. The good news is that Bob and Mary have to count only $2,500 of their $5,000 Social Security benefits this year in the “Provisional Income” formula. On the other hand, they have to count all of their “tax-free” municipal bond income, plus all of their traditional IRA income in the formula. As a result, their “Provisional Income” is $40,500. Now that Bob and Mary’s income is over the $32,000 “Provisional Income” test, they must report 50% of their Social Security benefits as ordinary income. The good news here is that $2,500 of their Social Security benefits are not reported as ordinary income. The bad news is that $2,500 of their Social Security benefits are now exposed to taxation.
Provisional Income, ROTH IRAs and Cash-Value Life Insurance
Understanding the “Provisional Income” formula sets the stage for the Roth IRAs and for cash value life insurance discussion. As noted before, income from these two products are not counted in the “Provisional Income” test. The result is that the addition of Roth distributions and withdrawals from cash-value life policies do not increase the tax profile of the family.
Going back to our example, if Bob and Mary had income of $12,000 from a Roth IRA rather than $12,000 of income from municipal bonds, their Provisional Income would be $28,500. The Roth IRA income lowers their tax profile, keeps their “Provisional Income” below the $32,000 test level and makes all of their Social Security benefits income-tax-free! The same logic applies to most withdrawals from cash value life insurance policies.
Balance is the key here. Most people understand that municipal bond income is income-tax-free. That is a fact. However, because it must be included in the Social Security “Provisional Income” test, it could very well trigger part of a client’s Social Security benefit to be taxed as ordinary income. Without balance and pre-planning, what appears to be a good idea can, in fact, result in a big problem in the taxpayers’ retirement plans. As income increases, the tax exposure on Social Security benefits also increases. The higher the tax profile, the less income clients have to support their retirement lifestyle.
This quote about taxation is attributed to Albert Einstein – “The hardest thing in the world to understand is the income tax.” Although I don’t want to match wits with one of the greatest minds of the 20th century, I do understand that keeping clients’ tax profiles low in the water will allow them to keep more of their money during retirement. Introducing Roth IRA withdrawals and cash-value life insurance withdrawals are excellent ways to reduce the tax profile of Social Security benefits. Advisors can clearly show their value added knowledge and expertise they guide clients through the issues around these important income sources which must be part of the balance between ordinary income and “tax-preferenced income” in retirement.