When the Social Security program began in 1935, President Franklin D. Roosevelt said it was not intended to be the only means of support for the aged but rather a social safety net. Subsequent generations, however, tended to regard Social Security benefits as a major part of their retirement funding.
Social Security’s role now appears to have come full circle. According to the AARP Public Policy Institute, the poverty rate for people over age 65 was just under 10% in 2009. Without Social Security, the rate would have been 45%. Members of the Baby Boom generation, some 77 million strong, are beginning to turn 65 this year. That group, known for spending, not saving, has been subject to a recent decline in the value of their homes and 10 to 12 years of securities markets that have returned nearly no equity growth, as well as historically low fixed-income rates. Today’s need for a social safety net is as great as in the Great Depression when the Social Security program originated. The difference this time is that its ability to pay full benefits beyond a 25-year horizon appears doubtful under current projections.
Social Security contributions from employers and employees in excess of benefit payments are placed in the Social Security Trust Fund and invested in interest-bearing, nonmarketable U.S. Treasury securities. Since last year, less money has been collected from wages each year than is necessary to pay Social Security benefits, and this is projected to continue for the foreseeable future (Social Security and Medicare Boards of Trustees, A Summary of the 2011 Annual Social Security and Medicare Trust Fund Reports ). Without any changes to the system, the trustees of the Social Security program project that the trust fund will be able to pay only 77% of full benefits starting in 2036, although the percentage would fall only slightly over the subsequent 49 years.
Will changes be made soon to keep the program at 100%? Until legislation is passed that addresses this difficult issue, practitioners should use 75% of estimated Social Security benefits in their retirement planning with clients and assure them that it is a solid figure they can count on.
Reducing or Eliminating Income Taxation of Social Security Benefits
Taxation of Social Security benefits began in 1983, and the dollar limits that determine the taxable portion of Social Security have remained constant such that many, if not most, of a practitioner’s clients must pay income tax on their Social Security benefits. How can tax advisers and their clients plan to minimize or eliminate the taxation of Social Security benefits?
First, a review of the rules: An individual or married couple adds one-half of the Social Security benefit received during a tax year to their modified adjusted gross income (MAGI). MAGI is adjusted gross income (AGI) further adjusted by any of a number of items, including the addition of any tax-exempt interest income that was excluded from AGI. If the total exceeds $25,000 for a single or head-of-household filer or $32,000 for a married couple filing jointly (base amount), 50% of the Social Security benefit usually is taxable. If the total exceeds a base amount of $34,000 for a single or head-of-household filer or $44,000 for a married couple filing jointly, 85% of the benefit is usually taxable. Social Security benefits are 85% taxable, with no base amount, for taxpayers who are married filing separately. Planning before receiving Social Security benefits could reduce or eliminate taxation of benefits for some clients.
Early distribution of deferred income: Many soon-to-be retirees have little after-tax savings but large pretax savings in their 401(k) pension plans. Rather than waiting until age 70½ to begin required minimum distributions (RMDs) from the plan, retirees should consider drawing from the tax-deferred plan sooner (after age 59½), once they are in a lower tax bracket than when they were working. At the same time, clients will be reducing the future pension assets and thus the eventual RMD amounts. They may also wish to wait until age 70 to begin collecting Social Security benefits and thereby increase their benefit amount by 8% per year, for a total of 32% more than they would have received at the current full retirement age of 66. Their higher Social Security benefit will offset the lower RMD caused by the distributions from the pension plan in prior years while perhaps reducing the taxable percentage of the Social Security benefit.
Roth conversions: Clients should convert taxable IRAs to Roth IRAs today. The MAGI limit for conversion of taxable IRAs to Roth IRAs has been lifted. Roth IRAs have no RMDs, nor are any distributions from them taxable for taxpayers age 59½ or older. Converting an IRA amount each year below that which would increase the client’s marginal tax rate would reduce future RMDs from remaining IRA assets. Clients should perform the conversions in years before collecting Social Security benefits because even small conversions could trigger higher taxation of those benefits.
Restructured investment portfolios: Practitioners should examine clients’ asset allocation between after-tax and deferred tax accounts. Many investment professionals without a strong tax background fail to consider taxes when planning investment portfolios. By structuring after-tax portfolios with more growth investments (which would likely produce capital gains) and placing the income-generating assets (e.g., those producing interest and ordinary dividends) in tax-deferred accounts, taxpayers can subject currently taxable investment income to the capital gains rate. Careful investment planning throughout the year can then take advantage of the markets to offset gains with losses, resulting in low or no reportable capital gain income and protecting Social Security funds from taxation.
Annuities: Placing after-tax assets in an annuity will allow for deferral of current taxation and could keep Social Security benefits from being taxable. Multiple annuities can provide flexibility for the stream of cashflows that clients need and help keep currently taxable income below the thresholds that cause Social Security benefits to be taxable.
Another consideration is the currently volatile investment markets. A client who has after-tax investments and a 401(k) pension plan is taking all the investment risk. An annuity can give an individual some peace of mind, knowing that a cashflow stream beyond the monthly Social Security check is secure no matter what occurs in the world. Relieving a client’s anxieties is a major step in having a satisfied client.
Social Security Disability and Survivors Benefits
Tax planning is a consideration when helping a client determine how to collect Social Security disability or survivors benefits. In either case, various family members may qualify to receive Social Security benefits, and there is a family maximum benefit.
Disability: A worker who qualifies for Social Security disability benefits (qualifications and approvals or rejections are determined by a federal judge of the Social Security system) will receive those benefits as long as he or she is disabled, up to full retirement age, when disability benefits cease and retirement benefits begin. Family members who can receive Social Security disability benefits on the worker’s record include the worker’s spouse if age 62 or older, the spouse of the worker at any age if caring for a child of the worker under age 16, and the worker’s qualifying children.
The taxation of disability benefits is the same as for retirement benefits. A disabled worker and a spouse working part time and collecting the spousal benefit could have enough benefits and income between them to cause taxation of the Social Security disability benefit. If the couple has two or more children, they will be subject to the family maximum benefit, and each beneficiary (spouse and children) would be limited proportionately. In this situation, the spouse should not collect the spousal benefit and should instead allow each of the children to collect a larger portion of the family maximum. The family’s total Social Security disability benefits would be the same, but the spousal benefit would be removed from possible taxation, dividing that amount between the children, who in most cases would not have enough income to cause taxation of the disability benefits on their individual income tax returns. Note, however, that the taxable portion of Social Security benefits is included in unearned income potentially subject to the “kiddie tax.”
Survivors: Family members allowed to collect Social Security disability benefits on a deceased worker’s record include the deceased worker’s spouse age 60 or older (including an ex-spouse who was married to the deceased worker for at least 10 years) or spouse at any age if caring for the deceased worker’s child who is under 16 or disabled, the deceased worker’s qualifying children, and the deceased worker’s dependent parents if age 62 or older. Taxation of survivor benefits is subject to the same rules as retirement benefits. Survivor benefits are also subject to a family maximum, computed using a similar formula to that used for disability benefits. Benefits received by a divorced spouse on a deceased worker’s record do not affect the family maximum benefit computation for the current spouse, children, and dependent parents.
A tax planner should suggest that the surviving spouse not collect a survivor benefit if there are more than two other potential beneficiaries. He or she is most likely going to need to work, which will cause most of the benefit to be taxable. When the family maximum is reached, allowing the children and dependent parents to collect their proportionate share of the family maximum will most likely result in no taxation of Social Security survivor benefits on their income tax returns if they file separately.
Other issues for the planner to explore with clients include the optimal time to begin benefits, the government pension offset, the windfall elimination provision, and divorce issues.
For approximately the next 20 years, 10,000 people a day will become eligible for Social Security retirement benefits (Social Security Administration press release, “Nation’s First Baby Boomer Files for Social Security Retirement Benefits—Online!” (October 15, 2007)) and will be looking to a tax practitioner to help them plan for the future. Practitioners should therefore make sure they are knowledgeable about this social safety net.
|Theodore J. Sarenski is president and CEO of Blue Ocean Strategic Capital, LLC, in Syracuse, NY. For more information about this column, contact Mr. Sarenski at email@example.com.|