Archives for July 2019

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The Effect of Taxes on the Social Security Filing Decision

A reader writes in, asking:

“Could you write something explaining the effects of taxes on the age you decide to begin Social Security. Especially since RMD’s may be delayed to age 72 under new legislation. Also, my state doesn’t tax Soc. Sec. benefits. Thanks.”

In most cases I have looked at, tax planning has worked out to be a point in favor of delaying.

The mechanism at work is that Social Security is, at most, 85% taxable. In contrast, distributions from tax-deferred accounts are usually fully taxable. And spending down your tax-deferred accounts in order to delay Social Security has the effect of increasing the portion of your lifetime income that is made up of (not-fully-taxable) Social Security and decreasing the portion of your lifetime income that is made up of (usually-fully-taxable) distributions.

And a similar thing is usually going on at the state income tax level. Only 13 states tax Social Security benefits, whereas a majority of states treat distributions from tax-deferred accounts as taxable income.

But, to be clear, the effect of taxes on the Social Security decision is very case-by-case. While the above effect is pretty broadly applicable, there could be any number of other factors that could point in the other direction. Almost anything that appears on a person’s 1040 could end up being a relevant factor in the analysis.

Ideally, the way to do the analysis (e.g., when comparing two possible claiming strategies) is to:

  1. Use tax prep software (or other similarly fully featured tax planning software) to estimate the total household tax bill year-by-year under each claiming strategy that you want to test. (For a married couple, you actually want to estimate 3 different tax costs for each year for each claiming strategy: a scenario in which both people are alive, one in which only Spouse A is alive, and one in which only Spouse B is alive.)
  2. Do a typical net present value calculation for each strategy, including the differences in tax costs as cash flows. For example, if you are comparing two strategies, and Strategy 2 has higher taxes by $1,000 in a given year, include that as a $1,000 negative cash flow for Strategy 2 that year. (Again, for a married couple, you would be doing three calculations for each year for each strategy — both spouses alive, only A alive, only B alive — then weighting each one by its probability, using a mortality table of your choosing.)

With regard to step #1, I would caution against using a spreadsheet or other similar DIY tax calculation. It’s very easy to accidentally fail to include a given credit/deduction/exclusion that would affect the analysis — especially when we consider state income taxes as well.

And of course it’s important to remember that all of this is just a projection. There are many unknowable factors involved.

Tangential note: my spreadsheet for doing step #2 of this analysis is what originally served as the starting point for the Open Social Security calculator. And it’s part of why I was surprised to realize that most (all?) other Social Security claiming calculators use a fixed life expectancy assumption in the calculation (i.e., assuming with 100% certainty that a person dies on a given date). Doing so is fine for an unmarried person, but for a married couple it significantly underestimates the length of time for which only one spouse will be alive. That really messes with the value of survivor and spousal benefits, and it also really messes up the expected tax cost calculation (because taxes change significantly once one spouse dies).

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."

Investing Blog Roundup: Taxes Made Simple, 2019

The 2019 editions of Taxes Made Simple and my book about taxes for sole proprietors are both now available. In contrast to the major changes that were necessary from 2017 to 2018 (due to the new tax law), the changes from 2018 to 2019 were relatively modest — inflation adjustments to various figures, minor improvements to wording here and there, etc.

Recommended Reading

Thanks for reading!

Simplifying a Retirement Bucket Portfolio

A reader writes in, asking:

If you were developing different “buckets” for a portfolio in retirement, what funds would you use for each bucket?

For our immediate 1-3 years, I have assigned that duty to the Vanguard Ultra Short Bond Fund. It has a duration of one year, and does not have any government bonds.

Do you think that fund is too risky – both in terms of duration and in terms of risk? Should we have at least one year in money markets?

For our 3-6 year buckets, we use a variety of short term bond funds – such as the Short Term Bond Index Fund, Short Term Investment Grade Fund, and the Short Term Corporate Bond Fund.

For 6-10 years, we use a variety of funds such as the Target Retirement Fund, and Wellesley (because the stock allocation is of extra large Value stocks). Also for this category we would consider the Life Strategy Conservative Growth Fund. Of course with this group our main investment is in the Total Bond Market Fund, with the others hopefully boosting returns over time.

For more than ten years, stock funds such as the Total Stock Market Funds, Total International Stock Market Fund, and the S&P 500, with a few exotic funds to spice things up such as the REIT. This portion is relatively small, as we will allocate our retirement duties to primarily bond funds, with a few funds such as what I mentioned before in the 6-10 year period. I look at the stocks as a really long term investment in the event more money is needed, but I will do some rebalancing of that bucket to take profits and put money in when the market falls.

What would be your suggestions? How many buckets and which funds go into each bucket?

Principle number one when it comes to crafting a portfolio is that it’s the whole portfolio that matters. This is why, for instance, it rarely makes sense to look at one account in isolation. And it is why the overall portfolio allocation is the important question here — both what allocation you want now, and how/if you want that allocation to change over time (i.e., your intended glide path).

Bucket strategies are psychological tools, not financial ones. That is, a bucket strategy can be helpful if:

  1. It helps you to arrive at an overall allocation (and glide path) that you’re happy with, or
  2. It helps you to stick with your overall allocation (and glide path).

For example, some people may find that the easiest way to settle on an allocation is to think of it in terms of buckets (e.g., “I want 3 years in short-term bonds, 7 years in intermediate term bonds, 15 years in stocks”).

And some people may find that having a bucketing strategy helps them to feel more comfortable sticking with the plan during a bear market (e.g., “I don’t have to worry about my stocks going down, because I have X years worth of spending in short-term bonds and Y years in intermediate term bonds”).

And some people may find that a bucket strategy may be the most intuitive way for them to implement a desired glide path. For instance, if you like the idea of a “rising equity” glide path (i.e., one in which your stock allocation rises over time, as suggested by Wade Pfau and Michael Kitces here), you might find that the most intuitive way to implement that glide path is via a bucket strategy in which you do not “refill” the shorter-term (bond-heavy) buckets (by selling stocks and buying bonds) as they get depleted over time.

But if you find that managing/crafting a bucket-based portfolio is harder than just focusing on the overall allocation, then it’s best to forget about the buckets.

What you’re describing sounds to me like it may be more funds and complexity than is necessary. Maybe that’s because of the buckets; maybe not.

For instance, you asked whether the Vanguard Ultra Short Bond Fund is too risky, and whether the portfolio should have at least one year in money markets. My questions there would be: how much of the portfolio is in the Ultra-Short Bond Fund? And how much would the portfolio’s overall volatility be affected by moving part of that money into a money market fund? (My guess would be “a relatively small portion” and “hardly at all.”)

And with regard to what you consider the 3-6 year bucket, what is the specific advantage (to the overall portfolio) of having three different short-term bond funds rather than just one?

Or more broadly I might ask, can you achieve the overall risk profile that you want using just a few funds (e.g., Total Stock, Total International Stock, Total Bond)? If not, why not? What specifically do you feel would be missing? (Alternatively, what do you feel that you’d have too much of?) And how could you fill that gap in as simple a way as possible?

For instance, if you like the idea of a larger helping of short-term bonds than you’d have with the Total Bond Market Fund, what about those three funds, plus a short-term bond fund? Would anything feel distinctly missing (or overweighted) then? (And if so, again, how could you correct whatever feels “off” in as simple a way as possible?)

Let’s assume for a moment that you would find those four funds to be sufficient. In that case, the portfolio could be thought of as a short-term bucket with a short-term bond fund, an intermediate-term bucket with a total bond fund, and a long-term bucket with total stock and total international stock funds. Or we could achieve the same thing by looking at it from the overall portfolio allocation perspective (e.g., 15% short-term bond, 25% total bond, 40% total stock, 20% total international stock).

If you find buckets to be helpful, great. But be sure, after creating a bucket-based plan, to step back and look at the whole thing at once.

  • How does the overall allocation look? Does it seem reasonable?
  • How will it change over time (i.e., will the equity allocation be roughly steady, increasing, or decreasing)? Do you like that?
  • Is there a way to achieve the same overall goal with fewer funds?
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My new Social Security calculator (beta): Open Social Security