All advisers who provide retirement advice must beware of two torpedoes that can materially affect how long clients’ money will last.
The first is the Social Security torpedo. Advisers can find a lot more money for clients by optimizing Social Security-claiming strategies, but the same care needs to be taken for coordinating a withdrawal strategy with Social Security.
All advisers must make sure that they don’t withdraw savings in a way that increases taxes on Social Security beyond household income thresholds. These mistakes can significantly drain a client’s assets by paying more to Uncle Sam.
Here is how it works.
First, calculate the taxes that a client will owe on Social Security based on the income thresholds that apply to the particular situation. For a married couple, the thresholds are $32,000 and $44,000 of provisional income, where 50% of Social Security is taxed 50% over $32,000 and 85% is taxed over $44,000 (provisional income is the sum of modified adjusted gross income, half of Social Security and tax-exempt interest).
Many advisers make mistakes with withdrawals from individual retirement accounts, i.e., tax-deferred accounts, pushing clients above a higher threshold without knowing it because they don’t calculate their client’s provisional income. This can be a costly mistake and large torpedo.
A simple additional withdrawal of $1 in tax-deferred savings can cause a significant tax increase.
For example, an adviser who thinks that the client is in the 25% federal tax bracket and withdraws IRA assets, pushing the client above the last income threshold, launches them into a 46.25% (25% x 1.85) tax rate. This is a hefty price from the extra IRA dollars withdrawn over this threshold.
The second torpedo is related to Medicare.
Many advisers don’t realize that how they tap client assets to generate income can materially impact clients’ Medicare premiums. These premiums are based on MAGI, where AGI is taken from the client’s tax return two years earlier.
Again, how the assets are withdrawn affects MAGI and thus can cause a client to hit this torpedo. This mistake occurs most often when advisers are withdrawing too much from the IRA or implementing a Roth conversion strategy.
It is easy to withdraw tax-deferred savings focusing just on investments and forget to look at the impact of the MAGI. Go $1 above these Medicare premium thresholds and the client’s premium can go up significantly.
For example, if an adviser converts an IRA into a Roth for a married couple, pushing them above $214,000 of MAGI, the monthly Medicare bill goes from $170.50 a month to $243.60 a month, representing a 43% increase. Clients will definitely notice this mistake as their health care bill goes up, and this can jeopardize the relationship with an adviser.
It is critical to navigate around this torpedo and ensure that the withdrawal strategy and how savings are tapped to generate income don’t push clients into a higher Medicare premium level.
So to avoid these problems: Beware of the torpedoes by checking that the withdrawal amount doesn’t hurt Social Security and Medicare; calculate provisional income and MAGI and map them to the graduated income thresholds; and, finally, construct a withdrawal strategy that makes sense.
Many times this is to stay under relative thresholds, but in some cases piercing a threshold may make sense. The best case is to run retirement income scenarios that include these tax calculations as part of the scenario.
This story is part of a 30-30 series on preparing for retirement.
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