How to plug Social Security tax drain and keep more money

Deciding when to start taking Social Security benefits depends on many factors, including how long you expect to live and the amount of financial resources at your disposal.
Income taxes and withdrawals from other retirement accounts also can influence the decision, yet
these factors often don’t get as much attention as they should. So says a new report from Prudential that, among other things, looks at the potential tax bite on Social Security benefits.
IRA withdrawals — or those from 401(k) plans, annuities and other investment accounts — can trigger taxes on Social Security benefits that otherwise might go untaxed, said James Mahaney, a Prudential vice president for strategic initiatives who wrote the report. Investors who delay withdrawing from these other accounts “are only creating a greater deferred tax liability,” he contends, since taxes eventually must be paid.

USA TODAY

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Spend down that IRA
Yet there’s often enough wiggle room regarding the timing of IRA withdrawals and Social Security benefits to minimize the tax bite. IRAs, 401(k) plans and Social Security itself provide flexibility on when to take income.
“If you want to make sure you’re maximizing your after-tax income, take some of that 401(k) and IRA money and spend that down first,” Mahaney said.
If Social Security is your only income in retirement, you won’t pay taxes on it. But if you have other sources of revenue, watch out. When it comes to taxes, Social Security benefits fall into one of three categories: For moderate-income retirees, all benefits might be untaxed. But for others, up to 50% of benefits — and possibly up to 85% — could be taxed.
Where the needle lands depends on how much Social Security and other income a person receives. Benefits avoid taxes if a single recipient earns less than $25,000 in income ($32,000 for married couples). Once that threshold is surpassed, up to 50% of Social Security benefits become taxable. Above a second threshold — $34,000 in income for singles (or $44,000 for couples) — up to 85% of Social Security benefits are taxable.
Those income thresholds are not indexed for inflation, which means more and more people will pay taxes on some Social Security benefits. “Eventually, all Social Security recipients will be taxed on 85% of their Social Security benefits, assuming the rules don’t change,” predict the authors of Get What’s Yours, a book focused on the government retirement program.
The income calculation is a bit tricky because muncipal-bond interest that’s normally tax-exempt gets included. Half of Social Security benefits also are included. But the key point is that withdrawals from IRAs and other retirement accounts, which can easily run tens of thousands of dollars a year, also get added in and can push a Social Security recipient into a higher-tax situation.
These tax basics, coupled with timing flexibility for both Social Security and IRAs, make certain strategies promising. The one proposed by Mahaney at Prudential starts with people in their 60s delaying Social Security benefits for as long as possible. You may start tapping into Social Security as early as age 62, but your monthly benefits will be larger if you hold off, preferably until age 70, when benefits are maximized.
Assuming you delay but need money in the meantime, you can supplement your income by starting IRA withdrawals earlier than you might have planned. The conventional wisdom of delaying IRA and related withdrawals isn’t the best choice for a lot of people, Mahaney argues. Some investors who delay will wind up creating a “greater deferred tax liability,” he said.