Why Does Delaying Social Security Provide Tax Advantages?

Many excellent 401(k) savers have heard about the value of Roth conversions to lower lifetime taxation, Yet, from my experience, few understand the value of delaying Social Security to reduce lifetime taxation. Going back twenty years, my research that became published by The Pension Research Council was the first to introduce the concept of lowering lifetime taxes through delaying Social Security. I suspect that the reason it wasn’t discussed in financial planning circles before that is that the math behind it is quite complicated. There are also two different references to “50%” of a number and that throws people off. Now that software has been developed to model the concepts, it’s now much easier to see that delaying Social Security is a tax planning move that works for many new retirees – even if individuals don’t widely understand why. Let me try to give explaining it a go. For simplicity, I’ll address a married couple.

First, Social Security income can avoid federal taxation if “Combined Income” stays below $32,000 annually. Between that threshold and $44,000, up to 50% of Social Security income can become taxable at the federal level. Above the $44,000 threshold, up to 85% of Social Security can become taxable. Notably, these thresholds are not indexed for inflation. As a result, IRA income can “force” the taxation of Social Security (which is in addition to the IRA dollar being taxed at the same time) . I wrote about this “Tax Torpedo” in my research mentioned above. I got the term “Tax Torpedo” from the Dallas Morning News columnist Scott Burns.

Conventional wisdom still exists that the Tax Torpedo cannot be avoided. Individuals will see the thresholds of $32,000 and $44,000 and say that their income will be much higher so they are resigned to a belief that taxation of their Social Security will occur and they can’t do anything about it. Yet, I find this belief wrong for many couples (and individuals).

The reason? Because the formula that determines Combined Income treats Social Security much more favorably than it does IRA income. Each Social Security dollar only counts as 50 cents in that formula. Hence, you could have $64,000 of Social Security go into the Combined Income formula before ever hitting the $32,000 threshold.

Therefore, if you delay Social Security until a later age, such as 70, you can “bridge” your income needs with IRA income (hence lowering your lifetime IRA income which could generate the Tax Torpedo). Once you reach age 70, your Social Security income is much higher and that income goes into the Combined Income formula in a favorable manner. Even if you have some IRA income once you start Social Security, the Social Security income might not be taxed as high as if you had started Social Security earlier and were now taking higher amounts of IRA income. The formula will tax the lesser of 1) 85% of Social Security benefits or 2) 50% of benefits plus 85% of any excess over the second threshold or 3) 50% of the excess over the first threshold, plus 35% of the excess over the second threshold. It’s this last calculation whereby individuals delaying Social Security can see federal tax savings.

Of note, most states do not tax Social Security benefits either. That might save you another 6% or more in taxes.

I told you it was complicated! But, it can add up and thank goodness for today’s software.

As my clients know, I use Income Lab software that does a great job of modeling smart tax planning.

Today, I ran a comparison of a 62-year-old South Carolina couple about to retire with $1 million in an IRA. The husband has a Social Security Primary Insurance Amount of $3,300 per month and the wife $1,000 per month. Hence, the wife will also see a spousal benefit once the husband claims his benefits. I asked the software to solve for the highest amount of after-tax income for each example and indicated the couple wanted to plan for above average life expectancy.

The only change I made between the two examples was to start Social Security at age 62 for both spouses in one example with the other example of starting Social Security at age 70 for both in the other. The results indicate that the lifetime after-tax income for the Delay to age 70 couple was 5.3% higher than the Start at 62 couple ($2,707,652 vs. $2,563,270) as taxes were $50,934 lower ($286,835 vs. $337,769).

This doesn’t mean your household can also necessarily reduce taxes by nearly 18% by delaying Social Security. This was just one example, and each new retiree household will be different due to their Social Security options as well as their other retirement wealth. But don’t make the mistaken assumption that the thresholds are so low at $32,000 and $44,000 that it won’t benefit you to delay claiming. You’ll need to run the numbers.

Yes, Roth conversions can be powerful tax moves. But so can delaying Social Security. And the combination of the two can significantly increase the after-tax income of many retirees.