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.