What Is Average Net Worth Of 70-Year-Old In United Statess Spend Your IRA First – Minimize Tax on Your Social Security

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Spend Your IRA First – Minimize Tax on Your Social Security

In a previous article, we explored why it’s best to spend your IRA first. The first reason was to delay taking Social Security until age 70 to maximize the inflation-adjusted income from a safe source, the United States Government.

The second reason was to have the IRA withdrawals taxed under the current tax structure because it is very likely that tax rates will increase in the future. If you delay your IRA withdrawals, they may be taxed at a higher rate.

The third reason, which was not covered in detail in the previous article, is to reduce the amount of money you will have to pay out of your Social Security earnings. We will cover this reason in detail in this article.

It may come as a nasty surprise to retirees that income tax must be paid on Social Security benefits if what the Internal Revenue Service calls your “provisional income” exceeds a certain limit. Provisional income is calculated by adding together your adjusted gross income, your tax-free income and half of your Social Security income.

The more income you receive, the greater your temporary income will be, and the more tax you will pay on your Social Security benefits.

If you are married and your temporary annual income exceeds $44,000, you will be in the higher level of temporary income and you could pay tax up to 85% of your Social Security.

When you spend your IRA first and max out your Social Security, you’ll get less from your IRA because more of your retirement income will come from your Social Security. This lowers your adjusted gross income, which in turn lowers your temporary income. Lower temporary income lowers your taxes on Social Security. This gives you more after tax income to enjoy in your retirement.

Let’s take the case of two married couples who file together. They plan for $70,000 a year in retirement income. For simplicity, let’s assume that both couples have the same Social Security benefits at their normal retirement age and both have the same amounts in their IRA.

Couple #1 begins taking Social Security at age 62 and receives $30,000 in annual Social Security benefits.

Couple #2 spends from their IRA first to delay taking Social Security. At age 70, they begin receiving Social Security benefits of $48,600 per year.

At age 70, the pre-tax income for each couple will be:

Couple #1 $40,000 from IRA plus $30,000 Social Security = $70,000

Couple #2 $21,400 from IRA plus $48,600 Social Security = $70,000

If you want to skip the final tax calculations, skip down to the “Final Tax Amount” section to see the tax savings of spending your IRA first.

Calculation of Provisional Income

For the calculation of temporary income we will assume that they did not receive any tax exempt interest.

Couple #1 $40,000 from IRA plus $30,000/2 Social Security = $55,000 temporary income.

Couple #2 $21,400 from IRA plus $48,600/2 Social Security = $45,700 temporary income.

As you can see, by spending their IRA funds and delaying Social Security, couple #2 lowered their temporary income by $9,300.

Calculation of Taxable Social Security Income

How much does that save in taxes? The IRS made this calculation difficult. You can access the form for this calculation on page 25 of the Instructions for Form 1040 on the IRS website.

Because these couples will exceed the upper limit ($44,000) for temporary income, the amount they will pay on Social Security income is calculated by doing two calculations and then taking the smaller of the two amounts from the calculations.

Calculation #1 = 85% of Social Security

Calculation #2 = $6,000 %2B 85% times (provisional income – $44,000)

For pair #1

The first calculation is 85% times $30,000 Social Security = $25,500.

The second calculation is $6,000 plus 85% times ($55,000 minus $44,000) = $15,350.

The lesser of the two calculations is $15,350.

For pair #2

The first calculation is 85% times $48,600 Social Security = $41,310.

The second calculation is $6,000 plus 85% times ($45,700 minus $44,000) = $7,445.

The lesser of the two calculations is $7,445.

Final Tax Amount

Now let’s calculate the total taxable income for both couples.

Taxable income for couple #1 will be total IRA income ($40,000) plus the taxable Social Security income ($15,350) = $55,350.

Taxable income for couple #2 will be total IRA income ($21,400) plus the taxable Social Security income ($7,445) = $28,845.

To calculate the tax that everyone will pay, we will use the tax rate of 15%.

Couple #1 will pay $8,303 and couple #2 will pay $4,327. Couple #2 will save $3,976 in taxes over couple #1.

By spending their IRA first, couple #2 will have $3,976 more each year to spend on their retirement. Multiply this over the years in your retirement and it will take you on some nice trips or allow you some pleasures that you otherwise wouldn’t have been able to enjoy.

In short, cashing out your IRA first can increase your Social Security benefits, lower your tax rate from potential tax increases in the future, and lower the tax you have to pay on your Social Security.

Disclaimer: The information in this article is general information. If you want to leave an estate to your children or if you are in poor health, concepts presented in this article may not apply to you. Seek professional advice from your accountant or professional adviser.

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