It is important for CPAs and advisors to recognize the difference between Social Security maximization and optimization. The Social Security maximization decision is based on math to target the highest lifetime dollar amount of Social Security income that the government will pay you. This is essentially a calculation that is done in a vacuum. This maximization calculation does not consider other aspects of the client’s bigger picture financial situation, such as income taxes and how other assets or income streams impact the taxation of the Social Security income stream. On the other hand, Social Security income optimization considers the Social Security income election technique and timing and includes other aspects of retirement financial and tax planning to work with the client towards harvesting the client’s maximum net after tax (i.e. post Uncle Sam!) lifetime income.
Some Social Security claimants think their Social Security income is, or will be, tax-free. For many, this may not be the case. Up to 85% of Social Security income may be taxable due to what is called provisional income. Provisional income, according to Kevin McCormally of Kiplinger, is “… basically your adjusted gross income plus any tax-exempt interest, plus 50% of your Social Security benefits.” In the media and amongst professionals this is often referred to as the stealth tax, because the taxation of the Social Security income benefit tends to “sneak up” on both consumers and tax professionals.
Several sources of income can contribute toward triggering the provisional income taxation thresholds for a client. These income sources may impact the taxation of their Social Security income benefit. These income sources include, but are not limited to, distributions from your 401k or IRA account(s), wages, pension income, CD and bond interest, and stock/mutual fund dividends.
Of course, clients ought to be mindful and attempt to minimize taxation of the Social Security income benefit if possible, and this often requires advanced planning. Therefore, it is important to investigate and determine in which sequence clients might draw upon their retirement income stream and/or retirement asset account buckets. When and how clients take their Social Security income can significantly enhance or reduce the longevity of their retirement assets and income stream.
Questions clients ought to be asking their advisor(s) might include:
• Should I take Social Security early or later?
• Which Social Security income election strategy will give me the most lifetime net after tax income?
• Does it make sense for me to first draw upon my 401K and/or IRA account(s) and then claim Social Security later?
• Does it make sense to re-distribute some of my assets into other investment vehicles that minimize, or altogether possibly eliminate, the taxation of my Social Security benefit?
The timing and election of the Social Security benefit in conjunction with investment and taxation management can lead to potentially higher standards of living in retirement for our clients.
Read more on considerations for adding Social Security planning to your practice.