Here’s a shocking statement: Some Social Security recipients are subject to the highest marginal income tax rates in the country — topping 55% in some cases — depending on their other sources of retirement income in a given year. What’s even more shocking? It’s true. Most advisers think of income taxes in terms of the federal tax brackets: 10%, 15%, 25%, 28%, 33%, 35% and 39.6%. But in the retirement space, taxes are different, particularly once clients turn 70½ and must start taking annual required distributions from their retirement accounts. Their effective marginal tax rate — the rate at which one additional dollar of income will be taxed when added to existing income — can be higher than the highest tax bracket.
Consider this example supplied by Social Security Timing, a software program for financial advisers to help their clients maximize their Social Security benefits: A married couple who is subject to required minimum distributions, has combined Social Security income of $50,000 per year, plus $15,000 in net long-term capital gains and $25,000 in IRA distributions. Because of the higher standard deduction for the elderly plus two personal exemptions, the couple is in the 15% federal tax bracket, and will pay 0% on their long-term capital gains. Then assume they need an additional $1,000 beyond their normal spending needs and decide to tap their IRA for the extra cash. In their 15% federal tax bracket, you would expect that a $1,000 IRA withdrawal would cost them $150 in federal income taxes. You would be wrong. That extra $1,000 IRA withdrawal will also drag 85% of an equivalent amount of Social Security benefits onto their tax return. The result: $850 of Social Security benefits will be taxed at 15%, adding another $127.50 to their tax bill ($1,000 x 0.85 = $850 x 0.15). The combined ordinary income and additional Social Security income pushes the $1,850 of long-term capital gains into taxable status. That additional tax of $277.50 on their long-term capital gains brings the total tax on their $1,000 IRA withdrawal to $550 — a 55% effective marginal tax rate.
A wise adviser who could foresee future spikes in marginal tax rates may be able to create tax-saving opportunities, said David Cechanowicz, director of education for Social Security Timing. The sweet spot for planning is generally between the ages of 66 and 70 if your client has retired, is willing to delay claiming Social Security and is not yet subject to minimal withdrawal requirements from his or her retirement accounts. “During that four-year period, you could either start doing Roth IRA conversions or harvesting IRA money,” Mr. Cechanowicz said. Taking a tax hit in one year can minimize taxes in subsequent years and reduce future RMDs. “By delaying Social Security and changing the blend of income, I have seen 90% reductions in taxes,” he added. “It can be quite magical if you structure it well, particularly for middle-income clients.” Of course, figuring out how to do that is a challenge. “The Bipartisan Budget Act of 2015 eliminated and is phasing out some Social Security claiming strategies that would have provided additional income to clients,” Mr. Cechanowicz said.
Full article may be found: http://www.investmentnews.com/article/20160201/BLOG05/160209997/retirement-income-hit-with-highest-effective-tax-rates Use is for educational purposes only. Neither Investment Planners, Inc. nor IPI Wealth Management, Inc. offer tax or legal advice. Please consult with an appropriately licensed tax consultant or attorney. Securities and investment advice offered through Investment Planners, Inc. (Member FINRA/SIPC) and IPI Wealth Management, Inc. 226 W. Eldorado St., Decatur, IL 62522. 217-425-6340.