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Some people claim early because they are afraid benefits will be chopped. What are the chances of this?
Play the odds (Photo illustration by Kevin Dietsch)
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“I’m 66. Married, filing jointly. I have high IRA balances. Also, no debt, our mortgage is paid, and we are both healthy and locally active with a low cost of living. I’m thinking about postponing Social Security until I turn 70.
“This will allow me to maximize Roth conversions with minimum taxes given my federal taxes, now barely into the 22% bracket. Once RMDs begin the marginal rate will hover above and below 24% (assuming 2021 tax brackets and current IRA balances).
“But, do I trust the government at this time? I can easily imagine ‘equity’ arguments, on top of insolvency realities, directly or indirectly reducing my full Social Security benefit by 50% rather than increasing it by 30% in three-plus years.”
Brian, California
My answer:
You’ve got three balls in the air:
—Social Security, which is shaky.
—Your taxes, which are going up.
—Roth conversions, which make sense, up to a point.
I’ll tackle these in order.
Social Security? It’s already insolvent. Its liability for accrued benefits is in the trillions, and its assets are currently $0, if you don’t count some phony IOUs in which the government is both the creditor and the debtor.
As for the P&L: Taxes being collected now aren’t enough to cover benefits being paid now. If you recollect that in a Ponzi scheme the money coming in from new victims is used to pay off the early investors, then you will see that Social Security is not a Ponzi scheme because it does not have sufficient financial integrity to be a Ponzi scheme.
The finances will reach a critical point in 2034, as the last of the phony IOUs are cashed in. Absent a law change, at that point benefits would have to be slashed 22% across the board. Will Congress allow this to happen? It could, but odds are very good that it won’t.
Will Congress double-cross retirees who postponed claiming? That would be the result if a cut in benefits landed disproportionately on people with high monthly payouts, or on recipients, like you, who have other resources. It’s possible but the odds are against.
I say that because I think it’s unlikely any reform will take money away from people who have dutifully paid in for a lifetime and are already collecting or are about to collect. There are other cures for the insolvency that are politically more tolerable.
One way to rescue the system is to increase the tax rate (for workers or employers or both). Another, addressing the long-term problems, would be to increase the retirement age, sparing people getting close to retirement. Yet another option, if progressives have the votes, is to eliminate the ceiling on taxable wages.
Under present benefit formulas, delayed claiming is a clear win for most people who are either healthy or else married to someone with a smaller earnings history. The reason it’s a win has to do with the faulty actuarial assumptions built into the formulas.
I think, Brian, that either you or your wife should delay claiming. The other of you can start earlier. The reason for this bifurcated strategy is that the higher benefit will be collected for as long as at least one of you is alive (a long time), while the lower benefit will last only as long as both of you are alive (a shorter time).
Next, taxes. It is customary to assume that tax rates go down in retirement. That’s a dangerous assumption in a world of federal deficits and giant holes in state pension plans. I can see that you have not made this mistake.
The 2017 cut in federal tax rates expires four years from now. Without an extension, which the present Congress is in no mood to enact, marginal rates for upper-middle-incomers are destined to jump three to four percentage points.
You have another problem. As you note, required minimum distributions from your IRAs threaten to toss you up into the next bracket. Although that doesn’t happen until 2028, you’re right to be thinking about the problem now.
Combine the RMD phenomenon with the tax cut expiration: You’re at risk of being launched from today’s 22% federal rate to 28% eventually. Add to that number whatever mischief comes from Sacramento over the next six years.
With your tax rate going up you are right to be looking around for ways to accelerate income. As noted above, taking Social Security early is, for actuarial reasons, not the optimum choice. You have another way to accelerate income. That brings me to the third element of your planning puzzle: Roth conversions.
With a conversion you opt to prepay income tax on some IRA money and wind up with total future tax freedom on that portion of your savings. There’s no mandatory distribution from a Roth account.
The arithmetic of converting works out this way: You come out ahead if (a) you can pay the tax due on the conversion without dipping into the retirement account itself, and (b) your tax bracket will stay the same or go up during retirement.
Yes, you should do some converting between now and when those RMDs kick in. You’ll be accomplishing two things. You’ll be taking advantage of today’s low rates, and by shrinking the balance of untaxed money in the IRA you’ll shrink minimum withdrawals down the road.
As noted above, conversions make sense up to a point. It’s often wise to fill up your current bracket, and sometimes wise to go beyond. Sketch out some forecasts for taxable income and see what different conversion amounts do. Also keep an eye on the break points for Medicare premium surcharges. Those premiums shouldn’t be an overriding factor in your planning, but they should be penciled out.
Leave some IRA money unconverted. That gives you valuable flexibility later in life, if tax laws or your circumstances change. For example, you might want to take a big distribution in a year when you have a large medical or charitable deduction.
Do you have a personal finance puzzle that might be worth a look? It could involve, for example, pension lump sums, estate planning, employee options or annuities. Send a description to williambaldwinfinance—at—gmail—dot—com. Put “Query” in the subject field. Include a first name and a state of residence. Include enough detail to generate a useful analysis.
Letters will be edited for clarity and brevity; only some will be selected; the answers are intended to be educational and not a substitute for professional advice.
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