A big surprise can occur when you see your Social Security retirement benefits being subject to income tax. This “tax torpedo” is often triggered by retirement account distributions.
Beware the Tax Torpedo!
Large retirement account balances can cause Social Security tax problems
Building a nest egg and holding a majority of your assets in your retirement accounts as long as possible may seem like a good idea, but waiting longer than you need to start taking distributions can also cause a tax problem. When you reach age 72, the trigger is pulled mandating required minimum distributions (RMDs) from qualified retirement accounts. These distributions may cause a tax torpedo to be launched!
RMDs apply to traditional IRAs, SEP IRAs, SIMPLE IRAs, 401(k)s, 403(b)s, and other defined contribution plans. Required withdrawals must be completed by April 1 following the year you turn age 72, and Dec. 31 every year thereafter. Amounts not distributed on a timely basis can be subject to a 50% penalty. (Thankfully the RMD rules do not apply to Roth IRAs!)
The RMD rules ensure the tax-deferred benefit you earned during your working years will be taxed during your retirement. The amount you must withdraw as your RMD each year is based on your age, your spouse’s age, and your filing status.
The tax torpedo!
If you wait to withdraw money from your retirement accounts until you turn age 72, the balance in those accounts may be extremely high. This will result in an RMD that may push you into a higher tax bracket. If your distribution is large enough, it may apply a higher marginal tax rate on your withdrawals, as well as trigger taxes on your Social Security income. Depending on your income and filing status, up to 85 percent of your Social Security income could now be subject to income tax!
What you can do
Thankfully, when you understand the risk of the tax torpedo, you can be more tax-efficient with your withdrawals each year. Here are some ideas:
- Plan withdrawals. Once you hit age 59½, you may withdraw money from qualified tax-deferred retirement accounts without experiencing an early withdrawal penalty. Manage annual disbursements from your retirement account(s) between the ages of 60 and 72 to effectively utilize your income tax bracket. You may not need the money now, but by being smart, you can lower the tax rate on some of your retirement income.
- Decide when to start collecting Social Security income. You may begin taking full Social Security benefits after you reach your minimum retirement age. In 2021, this minimum retirement age is 66 years and 10 months. However, your benefit amount can increase if you delay your start date up until age 70.
- See an advisor. Planning for retirement involves many moving parts. These include Social Security income, pension plans, savings, and retirement accounts. Ask for help to create the proper plan for you and your family. One element of the plan should include being tax efficient.
Remember, do not wait until the government tells you how much you MUST withdraw each year from your retirement accounts. A better strategy is to use each year to make tax-efficient withdrawals from these accounts. You might be surprised how much money you save by avoiding the tax torpedo!