No one likes a tax surprise, yet retirees may be subject to shockingly high marginal rates because of the complex manner in which Social Security income is taxed. Joint filers with $40,000 of total Social Security benefits and as little as $28,000 of other income can find themselves paying up to 185% of the normal marginal tax rate for their income level. IRA distributions and even supposedly tax-free municipal bonds are counted as income in these calculations.

Image: Bloomberg
Image: Bloomberg

Many baby boomers will confront this tax trap. Unlike previous generations, they are mostly two-wage earner couples, meaning they will collect higher total Social Security benefits. Affluent boomers have accumulated significant assets in IRAs and 401(k)s, which will produce substantial taxable distributions starting after age 70-1/2. Both factors will likely force many boomers firmly into the tax trap.

While it will be difficult for these clients to completely avoid the trap, there is a window of opportunity before they reach age 70-1/2 to mitigate some of the bite. This means considering strategies to shift taxable income off of future years as much as possible. Strategies include moving assets into tax-free accounts, tax-efficient investing and expense management.

Start with Social Security itself. If your clients are waffling about whether to delay the receipt of those benefits until 70, give them another compelling reason. Explain that delaying their filing for benefits may also help them minimize the impact of the tax trap in two marked ways.

If they delay, they may need to draw down some qualified savings as an income bridge between retirement and age 70. These early draw-downs will reduce future RMDs, thereby lowering future taxable income. Secondly, delaying their filing can provide a window to do some other tax planning.

Roth conversions are an obvious choice, especially before your clients reach age 70, when they would start collecting Social Security (presuming they delay) and begin taking forced RMDs. During their pre-70s years, clients may have significant space in the 15% federal tax bracket in which to work. If they have non-qualified assets with which to pay income taxes, they should consider Roth conversions potentially up to the 15% bracket limit of $75,300 for joint filers. This would lower RMDs and taxable income in future years. It would also generally give them greater tax-planning flexibility, since retirement saving would be spread more equitably between tax-deferred and tax-free accounts.

Clients should maximize contributions to Healthcare Spending Accounts (HSAs) if they are still working and using a high-deductible health plan, further moving assets into tax-free vehicles.

Tax-efficient management of nonqualified investments is also important, as it can lower future AGI and, by extension, combined income. This includes investment strategies that minimize capital gains, interest and dividend payments, and focuses more on growth. Staggering gains by consolidating them in some years, and minimizing in others, may also help.

Even municipal bond strategies should be re-evaluated. Municipal bonds could lose much of their tax-savings value as the bond income pushes Social Security income into the tax trap, effectively creating a tax on the muni bond income.

If the client is realizing profits from rental income, review the pros and cons of real-estate investments. There may be ways to shift more income into the pre-RMD years before age 70 or, conversely, plan income-lowering costs for repairs and the like after the client reaches 70-1/2.

Managing expenses may be another useful approach. Higher expenses naturally require more income. If that income must come from tax-deferred savings, this only pushes more income into the tax trap. Lowering expenses can help.

Mortgages are an obvious expense-lowering target, as they often represent the largest financial burden in retirement. Paying off a mortgage before starting Social Security would dramatically lower income needs and could reduce the requirement for additional taxable distributions in excess of RMDs.

Each client’s situation is unique. For those in the Social Security tax trap, the appropriate combination of strategies may help lower the tax burden and preserve more savings for future years.

Paul Norr

Paul Norr

Paul Norr is a certified financial planner with Bucks County Financial Planning Group in Thousand Oaks, Calif.