The Downside of Deferring Social Security
To be clear, delaying Social Security can be one of the most effective strategies to protect against longevity and inflation risk. The cumulative return of delaying from age 62 until 70 is 76% - not bad. Moreover, the real return over the course of retirement becomes significant once life expectancy starts creeping into the 90's.
And while deferring Social Security and replacing it with distributions from your retirement plan can be appropriate, it doesn't come without considerations. It's non-trivial that a.) you're not receiving Social Security today in order to consume things and b.) you're instead reliant on personal savings for that same spending need.
Less discussed are the possible tax implications from IRA distributions in lieu of Social Security. Whether or not Social Security is taxable is dependent on other income shown on a tax return. In this example, the client needed ~ $75k of annual spending money. This spending would be sourced from Social Security, IRA distributions, and taxable account distributions.
In this case, the client is receiving $22k (Social Security benefit) $24k (IRA distribution.) We took the remaining spending needs from the taxable account, where we had a huge window to take advantage of 0% long-term capital gains rates due to taxable income being light. $18k of the $22k Social Security benefit was excluded from income tax.
Let's compare this with another option. Instead of turning on Social Security, the client's wanted to explore deferring it another year, in order to take advantage of the benefit accruals already discussed. And let's assume this $22k needs to instead come from the IRA. What's the trade-off?
A higher tax bill. Because IRA distributions cannot take advantage of the tax exclusion that was applied to Social Security in our initial example, the overall tax liability goes up. In this case, nearly 10x (from $356 annually to $3,106 annually.) More taxable income will also result in a smaller window to take advantage of the 0% capital gain bucket.
It's also fair to note that the client would need to take a higher amount out from the IRA to meet their spending needs, due to the higher tax bill, creating even more taxable income. A good reminder that pre-tax dollars don't pay the bills.
In closing, this is not meant to encourage turning on Social Security early. In fact, my advice is usually quite the contrary. For most, the potential tax savings today won't come close to offsetting the hundreds of thousands of dollars more to be had in cumulative lifetime Social Security benefits that come with living into your 90's.
But be aware of these potential planning opportunities and how they can integrate with a very personal, client specific decision.
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The content in this article was prepared by the article’s author. Voya Financial Advisors, Inc. does not endorse its content, and the views expressed may not necessarily reflect those held by Voya Financial Advisors, Inc.
