Waiting until you're age 70 to claim Social Security benefits can increase your Social Security income by 8% for every year you delay, but delaying might not be smart if it means tapping an IRA to pay your bills.
First, some background on IRAs
Workers can contribute up to $5,500 of earnings to an IRA in 2017, or $6,500 if they're age 50 or older. Contributions to a traditional IRA are made with pre-tax money, while contributions to a Roth IRA are made with after-tax money.
Traditional IRA contributions are taxed when money is withdrawn in retirement, and people must begin taking required minimum distributions from traditional IRA's when they turn age 70.5. Withdrawals from Roth IRAs aren't subject to taxes, if certain rules are followed, and there's no requirement to withdraw money from them.
Now, some background on Social Security
Social Security provides lifetime monthly income to retired workers and their spouses. Qualifying for Social Security requires 40 work credits, or roughly the equivalent of 10-years of work history.
Reduced Social Security benefits can be claimed as early as age 62, however, recipients only receive 100% of their monthly benefit if they wait until their full retirement age to claim. Currently, the full retirement age is 66 and 2 months, but it is going to increase gradually every year until it reaches age 67 for people born in or after 1960.
Although you can collect 100% of your benefit at full retirement age, Social Security pays delayed retirement credits to those who wait until age 70. Those credits increase benefits by 8% per year, so a person with a full retirement age of 67 that waits until age 70 to begin receiving benefits will receive 124% of their full benefit amount.
When delaying doesn't make sense
A guaranteed 8% annual increase in income is incredibly tempting, especially since that's greater than the historical average annual return of the stock market since 2000.
Yet, holding off on claiming Social Security might not be the right move if it will force you to withdraw money from an IRA. That's because withdrawing money from a traditional IRA will result in taxes, and depending on your income, it could push you up into a higher tax bracket. Roth IRA withdrawals won't subject you to those tax risks, but the benefit of leaving money in a Roth IRA may more than offset any upside you get from greater monthly Social Security benefits after age 70, depending on the size of your Roth IRA account.
For example, let's say Jim has a $500,000 Roth IRA and $40,000 per year in retirement expenses. If Jim lives off his Roth IRA between age 67 and age 70, he'll need to withdraw $120,000. If he earns 6% annual interest on his Roth IRA assets during these three years, he'll be left with an account worth $467,233 at age 70.
If Jim's full retirement age benefit equals the average monthly Social Security payment of $1,360 that's being paid to retired workers in 2017, then waiting until age 70 to claim will net him $1,686.40 per month instead, which translates into an additional $3,916.80 in annual income.
Assuming Jim stops withdrawing money from his Roth IRA at age 70 so it can grow, and he earns 6% on that money per year, and he lives to age 90, he'll collect $424,956 in lifetime Social Security benefits and have a Roth IRA worth $1.5 million. Not bad, right?
But what would happen if Jim didn't use this strategy, took his benefits at age 67, and left his Roth IRA alone to grow at 6%? If he did that, he would collect $391,680 in lifetime Social Security benefits and his Roth IRA would be worth $1.91 million.
Therefore, while tapping his IRA would allow Jim to collect a bigger Social Security check, much of that benefit would be offset by the three additional years of Social Security he chose not to receive. Yes, he would still reap an additional $33,276 in lifetime Social Security benefits, but those extra earnings would cost him and his heirs more than $400,000 in retirement account value.
Admittedly, anything can happen, and there aren't any guarantees, but this example suggests that someone with a large IRA is better off claiming Social Security on time, rather than withdrawing money from it so that they can wait until age 70 to claim a bigger check from Social Security.