We’re taught to think of retirement savings as a source of last resort — money that we shouldn’t touch until all other resources have been used up. However, given the way the tax rules work in combination with the nature of Social Security benefits, it can often be in your best interest to use your retirement savings (IRAs, 401(k) accounts, and the like) to allow you to delay and maximize your Social Security benefits. Below is a version of a situation that I recently worked through with a client.
Tom, age 60 and recently retired, was in a unique position. He plans to relocate to New Mexico in retirement, and will be purchasing a home there. Tom has a pension of $18,000 with no cost of living adjustments and his needs for income (beyond housing purchase) will be $30,000 per year. Tom’s Social Security benefit is estimated at $12,000 per year if he delays taking the benefit until full retirement age, or $9,000 if he starts at age 62. Delaying his Social Security to age 70 would result in a total benefit of $15,840 per year.
Although Tom hasn’t picked out a home in New Mexico, he’s anticipating that the new home will cost something on the order of $200,000, with a mortgage of approximately $180,000. He’s planning to maintain his home in Ohio, in order to have a place to stay when he visits family, which will be a regular occurrence.
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Tom also has an IRA worth $300,000. His plan has always been to use the IRA when necessary for living expenses, and pass along the remainder of the account, if any, to his siblings. With the above facts, here’s what Tom had originally planned:
Tom takes out a mortgage on his new home in the amount of $180,000. He can get a 25-year mortgage at a rate of approximately 3.5%, which would add approximately $10,813 to his annual expenses for the payments. Since he doesn’t have a large enough income from his pension to cover his other living expenses, he’ll need to augment the pension with disbursements from his IRA, in the amount of $12,000. When you add the cost of the mortgage, he will need to withdraw a total of $22,813 from his IRA each year. When Tom reaches age 62 he will file for Social Security, and he can reduce the amount of his IRA disbursements annually by the $9,000 that his Social Security benefit replaces.
The Updated Plan
A much better result can be found for Tom if he takes a different tack — one that sees his IRA as more expendable and which maximizes the Social Security benefit that he’ll receive, while at the same time reducing his interest costs for the mortgage. This is a dramatic departure from conventional wisdom — shortening the length of a very low-cost mortgage, and using IRA funds in a much quicker fashion.
We’ll see a bit later that the mortgage and the IRA aren’t the critical components — this updated plan is a much more tax-efficient use of the available resources. Here’s how the numbers play out for this option:
Tom can take out a 10-year mortgage on his home, at a cost of approximately 2.5%, which results in payments of $20,362 per year. Again, since he can’t cover his total living expense requirement with his pension, Tom must augment his income with IRA withdrawals to cover both the expenses and his mortgage payment, so he’ll need to withdraw approximately $32,362 from his IRA each year. In addition, Tom will delay filing for his Social Security benefit in order to maximize it — he won’t file for benefits until age 70, for a benefit of $15,840 per year.
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So — if we assume that the IRA grows by a rate of 5% per year, at the end of ten years when Tom is 70, using the first method he will (upon reaching 70½) have to take Required Minimum Distributions (RMDs) from the IRA that are larger than his needs. His IRA will have a balance of roughly $287,665, and the first RMD would be almost $17,000, when he only needs $13,813. This excessive withdrawal requirement will be fully taxed as ordinary income; he can invest the remainder in a taxable account (if there is any after taxes).
Using the second method, Tom’s IRA is down to $81,618 by age 70½, so his RMD is much, much smaller, approximately $3,961. On top of that, he has now paid off his mortgage, so the only amount he needs for expenses is the $30,000. With his pension and the maximized Social Security he has $33,840 coming in, so he has an excess of $7,801 ($3,840 Social Security and $3,961 from his IRA), which he uses to pay his income taxes and invests the remainder in a taxable account.
But here’s the really cool part — because Tom’s RMD is so small, it keeps a large portion of his income at very low tax rates, and much of his Social Security is not taxed at all! Under the current rules, only approximately $2,440 of his benefit is taxed, and that portion is only 50% taxed. As a result, Tom’s total income is only 65% taxed — and his effective tax rate is 2.76%. Under the original plan, more than two-thirds of Tom’s Social Security benefit is taxed, and his effective tax rate is 7.65% at that stage. Plus, he still has 15 more years of interest to pay on his mortgage!
The favorable tax treatment of Tom’s Social Security benefit continues throughout his life — at this stage he’ll wind up paying something around or less than 3% in income tax for the rest of his life. On the other hand, since the first plan resulted in a much larger amount of his reduced Social Security benefit being taxed, and the preserved IRA forces him to recognize additional income that he doesn’t need (but is taxed on, nonetheless!), he will continue to pay taxes at effective rates ranging up to approximately 8.7% for the rest of his life. This doesn’t even address the additional interest he’s paying over the additional 15 years (at a higher rate) for the longer-term mortgage.
With some shrewd planning, Tom winds up paying $60,000 less in interest, $22,000 less in income taxes, and still has $245,000 left in the combination of his IRA and his taxable account at age 85. By comparison, after paying the additional taxes and interest, Tom would have approximately $251,000 in his IRA at age 85 — and in both cases his home is now paid off. The difference is that his future income will continue to be taxed at nearly triple the rate under the original plan as it is with the revised plan. Tom can enjoy his paid-off home much earlier, and at the same time enjoy nearly tax-free income, and still leave a legacy for his siblings.
Note: the cost-of-living adjustments (inflation and Social Security COLAs) have not been factored in the calculations above. In addition, only the current tax tables (2013) were used for projecting taxation, and the current rules for Social Security benefit taxation have been used. This was done to keep from confusing the process and to preserve clarity. The primary place that inflation, COLAs and tax rates would impact the calculations is in the amount of taxation of the Social Security benefit, but the expectation is that inflation, COLAs and tax tables will increase in tandem, more or less at the same rates over time. The affect is that the second method would still result in lower costs of interest and lower taxes in the long run, but the future numbers are bound to be different from the projections.
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