Most people are aware of the advice “delay your Social Security until age 70.” Many reject it because they created an Excel spreadsheet that seems to contradict it, or they think they won’t live long enough to make it pay off, or because they just can’t stand working past age 65 (or 66 or 67). In addition, they look at the idea of putting off taking Social Security by funding their living expenses with withdrawals from their IRAs or 401(k)s with disdain, because those accounts are 100% taxable upon receipt and they hate “giving money to Uncle Sam.”
Unfortunately, for many people, the decision to start Social Security before age 70 and delay withdrawing money from a traditional IRA until age 70½, when required minimum distributions (RMDs) begin, is completely backward.
Let’s break this down into three main points:
1. You’re giving up on a higher Social Security benefit.
Once you reach your full retirement age, your monthly Social Security check gets 8% larger for every year you delay taking benefits through age 70 (technically, it’s 2/3% per month). Mathematically, the “crossover point” is about 12 years.
For example, suppose at full retirement age (which is 67 if you were born in 1960 or later) your Social Security check is $2,000 per month (or $24,000 per year). At age 70, that check would be $2,480 per month ($29,760 per year). By waiting until age 70 to start taking benefits, by the time you reach age 83 you would have been paid a total of $386,880, compared with the $384,000 you would have gotten if you had started at age 67, even though you got income for three extra years. The average life expectancy of a 67-year-old is at least 85, and growing, so any year you live past age 83 is money in your pocket.
Basically, the advice to delay Social Security is correct.
2. You’re still going to have to pay taxes on your tax-deferred accounts no matter what.
Your traditional IRA, 401(k), 403(b), etc., is 100% taxable to you or your heirs, and at some point it will be fully liquidated to you or them. Putting off taking withdrawals from it does not change those facts. You get no tax benefit by delaying.
3. It’s not how much money you make that counts, but how much you keep.
Social Security income is never more than 85% taxable, but it could be 0% taxable. The taxed amount is determined by an 18-step calculation in the return instructions for Form 1040. Essentially, the process tells you to take half of your Social Security benefit, add that to all your “other income” and then perform a series of calculations to determine how much of your Social Security (between 0% and 85%) is taxable.
In other words, the bigger your Social Security check and the less “other income” you have (for the same total income), the less your adjusted gross income and the less tax you will pay.
Putting this strategy to work: One couple’s story
The realization of these three points offers insight into sound retirement planning: If you plan to retire before age 70, consider delaying your Social Security until age 70 and living off your retirement accounts from your retirement date until then.
For example, Bob and Mary, both age 65, have just retired. Together, they receive pensions of $1,500 per month and are eligible (at age 65) for combined Social Security benefits of $3,500 per month ($42,000 per year). They need $5,000 per month for their living expenses. They also have 401(k)s worth $300,000.
Succumbing to “conventional wisdom” myths, Bob and Mary start their Social Security at age 65, justifying that in combination with their pensions, they’ll get the $5,000 per month they need. Over the next five years, their 401(k)s grow at 5% per year. Five years later, they are worth $382,884 with a first year RMD of $13,306. Their gross annual income is $73,306, of which only $13,360 of their Social Security is taxable. Their adjusted gross (taxable) income is $44,366. Bob and Mary are happy.
Conversely, if they delayed their Social Security and instead withdrew $3,500 per month from their 401(k)s until age 70, at that time their 401(k)s would have been depleted to under $140,000 and they would generate a first year RMD of $6,371. But, by waiting, their Social Security has grown by 8% per year for five years and now pays $58,800 per year of which only $14,305 is taxable. Their gross income has increased to $83,171 and their adjusted gross (taxable) income has dropped to $38,676. In other words, while their total income increased by $9,865, their taxable income fell by $5,690. That’s a net improvement of $15,555, and this advantage will continue for the rest of their lives.
Further, whoever dies first, the survivor will get the larger of the two Social Security checks, either of which is now a lot larger by having waited. This is important, because the surviving spouse’s standard deduction just got reduced by half and having more 100% taxable income from 401(k)s (vs. Social Security) may serve to increase the total income tax load. If Bob and Mary are of different ages, whoever passes first, the survivor gets to assume the other’s 401(k) and take RMDs on that account based on the age of the younger spouse.
Finally, if Bob and Mary have any non-IRA type investments, they can grow those without spending them down for routine income. If an emergency arises, they can access that money at a lower tax rate (long-term capital gain) and if they don’t need the money, when they pass that money transfers to their kids with a Step-up in Income Tax Basis, meaning their kids will owe no income tax on that money if liquidated at the time of inheritance. That’s not the case with IRAs.
The value of delaying Social Security until age 70 is far more than just getting “more money per month.” There are tax advantages, surviving spouse advantages, even inheritance advantages when the entire portfolio and estate are considered as a whole. However, there are times and circumstances when this advice is not suitable, and this is the reason for seeking professional financial guidance before implementing decisions about when to start Social Security and when to start withdrawing from your IRA, 401(k), etc.
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