Is Tax Planning a Good Reason to Delay Social Security?

A reader writes in, asking:

“I have a Social Security strategy that I have not read of or heard about. I am interested in your feedback. Given the size of my tax-deferred accounts, when I am 70 1/2, RMDs will make it such that I will pay tax on the maximum 85% of my Social Security benefits regardless of when I start benefits. I am considering taking benefits at age 62, so I can pay no taxes on the benefits for 8 years, then pay the full tax on the benefits at age 70 1/2 and beyond.”

Unfortunately, tax planning with regard to Social Security is a very case-by-case sort of thing.

Also unfortunately, a comprehensive analysis tends to be very time-consuming. In my opinion, the only way to do it appropriately is to use actual tax planning/preparation software and run through several years of simulations using Strategy A and several years using Strategy B, then compare the results (often in a spreadsheet). When I see people trying to do a DIY spreadsheet-only analyses rather than using tax software, they often end up leaving out something important (e.g., a credit for which they’re eligible in one case, but not in the other — or a tax to which they’re subject in one case but not in the other).

As such, I am convinced that this is one of the areas in which working with a financial planner can be most worthwhile.

With the above caveats, I would say that tax planning tends to be a point in favor of delaying Social Security, for two reasons.

First, each dollar of Social Security income is, at most, 85% taxable. So if a person has the option to, for example, spend down their IRA to delay Social Security and the net result is $100,000 less of IRA distributions over their lifetime but $100,000 more of Social Security benefits, that ends up being a “win” from an after-tax perspective.

Second, increasing the portion of one’s income that is made up of Social Security often results in a smaller portion of Social Security being taxable (because only 50% of benefits are included in the “combined income” figure that determines Social Security taxability).

That is, for many people, delaying Social Security results in:

1. a larger portion of their lifetime income being made up of tax-advantaged dollars of Social Security and
2. a smaller portion of those Social Security dollars being taxable.

But the above points don’t always apply. For instance, for the reader who wrote in with the question, it appears that even if he delays benefits and spends down tax-deferred accounts in the meantime, 85% of his benefits will still be taxable.

And there are other factors involved as well. Ultimately, the best claiming strategy often depends on whether there are other tax breaks you’re looking to qualify for or other taxes you’re looking to avoid. For instance, for a person who retires prior to age 65 and who will be buying health insurance on the exchange, keeping “household income” very low until Medicare eligibility kicks in may be very desirable, as Affordable Care Act subsidies can be quite large. And that typically means delaying Social Security (at least until 65) while spending primarily from taxable accounts and Roth accounts.