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Social Security and Tax Planning

A reader writes in, asking:

“I think there is more to deciding when to file for SS income than just the maximum benefit. I plan to coordinate SS with regular IRA, Roth IRA, and portfolio income in order to avoid as much taxes as possible. Any recommendations for how to optimize for the total portfolio?”

The tax aspect side of Social Security planning is very case-by-case (just like any tax planning, really). In a majority of cases I have looked at though, it has turned out to be a point in favor of delaying — for two reasons.

The first reason is that Social Security is taxed favorably relative to most other types of ordinary income such as distributions from tax-deferred accounts. So it’s usually advantageous to spend down tax-deferred accounts in order to delay Social Security — with the effect being to reduce the percentage of lifetime income that’s made up of tax-deferred distributions (which are normally fully taxable) and increase the percentage of lifetime income that’s made up of Social Security (which is not fully taxable).

The second reason is that, once you start receiving Social Security benefits, your marginal tax rate on other types of income could increase significantly. (Not only because you have a new source of income, but also because of the way Social Security is taxed, in which one additional dollar of ordinary income can cause not only the normal amount of income tax, but also cause 50 or 85 cents of Social Security to become taxable.)

Delaying Social Security gives you some years with a relatively lower marginal tax rate prior to that higher marginal tax rate kicking in. It’s often advantageous to spend down tax-deferred accounts (and often do Roth conversions as well), thereby making use of the relatively lower marginal tax rate in the pre-Social Security years. In some cases, this has the additional benefit of allowing your Social Security to remain nontaxable once it does begin, because your “combined income” is below the applicable threshold due to having done conversions.

To summarize, there are multiple mechanisms that point in favor of the same exact plan: delaying Social Security and using that pre-Social Security period of time to spend down tax-deferred accounts and make some Roth conversions.

But again, tax planning is case-by-case. Basically anything that appears on your Form 1040 could be a relevant factor, and some of them could point in the opposite direction (i.e., in favor of filing for benefits earlier rather than later).

Working with a financial planner can provide a lot of value here.

For anybody taking a DIY approach, I would caution that attempts to actually do the tax calculation on your own (e.g., with just a spreadsheet) are as likely to be harmful as helpful. DIY tax calculations frequently fail to account for all of the various income-threshold-based tax provisions that can apply to a person. A better method is to use tax-prep software (which can account for the phaseouts/phase-ins of every applicable tax provision) to run hypothetical year-by-year calculations in different scenarios. Then record those results in a spreadsheet (or other software of your choosing) and factor them into a broader analysis.

Want to Learn More about Social Security? Pick Up a Copy of My Book:

Social Security cover Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less
Topics Covered in the Book:
  • How retirement benefits, spousal benefits, and widow(er) benefits are calculated,
  • How to decide the best age to claim your benefit,
  • How Social Security benefits are taxed and how that affects tax planning,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"An excellent review of various facts and decision-making components associated with the Social Security benefits. The book provides a lot of very useful information within small space."

2020 Editions: Investing Made Simple, Sole Proprietor Taxes, LLC vs. S-Corp (Also a Roundup)

Just a quick announcement today. The 2020 editions of three of my books were released this week. You can find them at the links below:

In each case the book has been updated for any applicable tax changes — both legislative changes and inflation adjustments to various figures.

In Investing Made Simple the chapter about working with a financial advisor has been reworked to discuss not only the differences in compensation (e.g., hourly fees as opposed to AUM fees as opposed to commission) but also the fact that different advisors actually do different things for you (e.g., some advisors focus exclusively on managing your portfolio, while others provide broader financial planning).

Other Recommended Reading

I hope you’re well, and thanks for reading!

Using a Roth IRA for a Home Down Payment

A reader writes in, asking:

“What do you think about using a Roth IRA for a home down payment?”

This is a topic that generates endless disagreement, in part because when somebody asks this question, they can actually be asking either of two completely separate questions:

  • What do you think about taking money out of a Roth IRA, to use it as a down payment on a home?
  • For money that is already intended to be used as a down payment on a home, what do you think about contributing it to a Roth IRA (as opposed to simply leaving it in a taxable account)?

Let’s tackle the first question first, then the second. But before directly addressing either of those questions, we need to talk about the actual rules: how are distributions from a Roth IRA treated, when used for a home down payment?

Tax Treatment of Roth IRA Distributions When Used for a Home Purchase

Money that you contribute to a Roth IRA can come back out of the account at any time, free from tax and penalty. (Note: this is only for amounts that were contributed directly to the Roth IRA. For amounts that were contributed to a traditional IRA, then moved to a Roth IRA as a conversion, see this article.)

In addition, a distribution of earnings is free from the 10% penalty if it is a “qualified first-time homebuyer distribution.” And if you have satisfied the 5-year rule, the distribution will be free from regular income tax as well.

For a distribution to be a qualified first-time homebuyer distribution:

  • It must be used within 120 days of the distribution…
  • to pay “qualified acquisition costs”…
  • on a “principal residence”…
  • for a “first-time homebuyer.”
  • And the homebuyer in question must be yourself, your spouse, one of your (or your spouse’s) ancestors, or one of your (or your spouse’s) descendants.
  • Also, qualified first-time homebuyer distributions are limited to $10,000 over your lifetime. (Though if you’re married, your spouse gets his/her own $10,000 limit.)

As far as definitions:

  • “Qualified acquisition costs” means what you would expect: costs of acquiring, constructing, or reconstructing a residence. And it includes any usual or reasonable settlement, financing, or other closing costs.
  • “Principal residence” also means what you would expect: your main home. If you have more than one home, the IRS takes a “facts and circumstances” approach to determining which one is your main home. (You can find more information in Treasury Regulation 1.121-1(b) if you’re interested.)
  • A “first-time homebuyer” is anybody who had no present ownership interest in a principal residence during the 2-year period ending on the date of acquisition for the home in question. If you are married, your spouse must also meet this requirement in order for you to qualify.

Using Money from a Roth IRA for a Home Down Payment

The decision of whether to buy a home obviously has many factors involved, many of which are not financial at all. Let’s assume that that decision has already been made and that you do intend to buy a home, so the question remaining is simply whether you should use money from a Roth IRA for the down payment.

When it comes to using assets for a home down payment, the general order of preference is as follows:

  • Best to use taxable money (i.e., assets that are not in a retirement account at all — just regular checking/savings accounts and taxable brokerage accounts),
  • Next-best to use “qualified first-time homebuyer distributions” from a Roth IRA,
  • Next-best to use distributions of contributions from a Roth IRA — or distributions of converted amounts if those distributions would not be subject to the 10% penalty (e.g., because the conversion has satisfied its 5-year period or because the conversion was not taxable),
  • Next-best to use other distributions (e.g., distributions of earnings) from a Roth IRA, distributions from a traditional IRA, or distributions from an employer-sponsored plan such as a 401(k) or Roth 401(k).

So the question then is: how much taxable money is there? If you have sufficient money in taxable accounts that you can cover the down payment that you want to make (while still having an emergency fund), then it’s an easy decision: don’t take money out of your Roth IRA for the down payment. Use the taxable assets instead.

If, on the other hand, you do not have sufficient assets in taxable accounts to fund the down payment, then the question is essentially: should you use Roth IRA money or delay the home purchase? On the financial side, whether waiting would pay off depends on:

  • Whether another home comes available for sale that meets your criteria and which is approximately as affordable.
  • What rate of return you earn on the assets that stay invested in the Roth IRA while you wait to build up your savings.
  • Whether interest rates move upward or downward (because you will be getting a mortgage in the future, at those future interest rates, rather than at today’s rates).

And again, there are of course an assortment of non-financial factors that could, quite reasonably, affect your decision as to whether to wait or go ahead and buy the home in question now.

Contributing to a Roth IRA to Save for a Down Payment

A separate but related scenario is the case of somebody who plans to buy a home in the not-so-distant future, and they want to know whether it makes sense to put money into a Roth IRA when that money is likely to be used for a down payment. In other words, the question is basically “make Roth IRA contributions or do not make Roth IRA contributions.”

And the answer here is generally to go ahead and make the contributions, even if the money in question is intended to be used for a home down payment rather than retirement. There are a few reasons for this:

  1. There’s not much of a downside from a tax perspective, given the way that distributions are treated when used for a first-time home purchase.
  2. Making Roth IRA contributions may allow you to qualify for the retirement savings contribution credit.
  3. And perhaps most importantly, if you later change your mind about the home purchase (or decide to delay it for other reasons), you will not have missed out on your Roth contributions for the year(s) in question.

There are two related points to note here.

First, if the money in question is intended to be used in the relatively near-term future, it should of course be invested conservatively.

Second, this general concept does not apply to Roth 401(k) contributions. If you have money that you intend to use in the near future for a home down payment, do not contribute it to a 401(k) — even a Roth 401(k). In some cases you won’t be able to get money out of a 401(k) at all until you have left the employer in question. And the special tax treatment (discussed above) that sometimes applies to distributions from an IRA when used for a home purchase does not apply to distributions from a 401(k) (whether Roth or not).

For More Information, See My Related Book:

Book3Cover

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

Investing Blog Roundup: Open Social Security Can Now Save Inputs

Just a quick note about the Open Social Security calculator: it now offers an option to save your inputs. There’s a link at the bottom of the page. Right-click that link and save the URL. When you revisit that URL, your prior inputs will be pre-filled.

This way you can come back later to revisit a calculation, or you can easily share it with somebody else (e.g., another member of your household or your financial planner).

Recommended Reading

I hope you are well, and thanks for reading!

Using an All-in-One Fund During a Downturn

A reader writes in, asking:

“You’ve written before about using a Vanguard Lifestrategy fund for your retirement savings. Have you been happy with its performance through all of the volatility this year? Do you think it has made it easier to ‘stay the course’ as Bogleheads say?”

To be clear, my level of satisfaction with the fund is not really a function of its performance. It’s just a fund of index funds. And because we use the LifeStrategy Growth fund, it has a mostly-stock allocation (80% stock, 20% bond). So if the fund is doing well at a given time, that’s just because the global stock market is doing well, not because of anything brilliant about the fund.

Similarly, when the fund is performing poorly (e.g., Feb-March of this year), that’s not a failing of the fund. It’s just what happens when you own index funds and the market performs poorly.

Having said that, yes, we are happy with the fund. And yes, it probably has made it somewhat easier to “stay the course” through all the volatility.

It has been nice not to have to think about when to rebalance or anything like that. All we’ve had to do is just keep putting money into the same fund (i.e., precisely the same thing we’ve been doing since we began using the fund ~8.5 years ago). It’s a very low-stress, low-hassle way to save and invest.

Granted, I imagine that if I were using a DIY allocation, I still would have been able to calmly continue with the plan (i.e., continuing to contribute and rebalance). I had no trouble doing so in the bear market of 2008-2009, and that was a worse decline (in terms of percentage).

And, to be clear, the behavioral/psychological benefits that I’ve experienced with the LifeStrategy fund are not particular to LifeStrategy funds. They’d be just as applicable to any “all-in-one” fund, including target-date funds or balanced funds.

And finally, the same caveats as always apply:

Investing Blog Roundup: 2020 RMDs (You Can Put Them Back)

The CARES Act waived RMDs for 2020, but of course many people had already taken their RMD for the year by the time the CARES Act was passed on March 27. This week the IRS announced that you can roll those assets back into a retirement account (by 8/31/20), without having to worry about the normal “60-day rule” or “once-per-year rule.”

Other Recommended Reading

I hope you are well, and thanks for reading!

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My new Social Security calculator (beta): Open Social Security