Many people recommend delaying Social Security retirement benefits until age 70, because you earn delayed retirement credits for every month you delay past your full retirement age. Someone claiming at age 70 will receive checks 24% larger than if they claimed at 67. And who doesn't want a bigger check?
But delaying your Social Security checks until age 70 can also help you keep more of your money instead of having to pay the government back in higher taxes. Here's why.
Image source: Getty Images.
The tax benefit of bigger benefits
The way taxes on Social Security benefits work is by using a metric called combined income. Combined income is the sum of your adjusted gross income, any non-taxable interest, and 1/2 of your Social Security benefits.
If your combined income exceeds a certain threshold, a portion of your Social Security benefits become taxable. Here's how it breaks down.
| Taxable Amount | Single | Married |
|---|---|---|
| 0% | <$25,000 | <$32,000 |
| 50% | $25,000 to $33,999 | $32,000 to $43,999 |
| 85% | >$34,000 | >$44,000 |
Table by author. Data source: Social Security Administration.
Yes, those thresholds are very low. That's because they haven't been adjusted in almost 40 years. So, it behooves you to minimize your combined income. One way to do that is by drawing a bigger portion of your total income from the part where only half counts toward the equation: Social Security.
What a difference eight years can make
Imagine a couple retiring at age 62 with the following financial profile:
- $1 million portfolio in pre-tax retirement accounts.
- They spend $67,000 per year in retirement, and taxes come out of their spending money.
- Both spouses had average careers and are each eligible for $1,625 in Social Security benefits at their full retirement age of 67.
The table below summarizes their tax liability (based on 2022 tax rates) if they claim Social Security benefits at age 62 versus delaying until age 70.
| File at 62 | File at 70 | |
|---|---|---|
| Social Security income | $27,300 | $48,360 |
| Taxable retirement account withdrawals | $39,700 | $18,640 |
| Combined income | $53,350 | $42,820 |
| Taxable portion of Social Security | $13,948 | $5,410 |
| Adjusted gross income | $53,648 | $24,050 |
| Standard deduction | $25,900 | $27,300 |
| Tax liability | $2,919 | $0 |
Table by author. Calculations by author.
The couple who wait to claim their Social Security benefits will see their annual taxes fall to $0 once they start supplementing their retirement withdrawals with Social Security. That said, they'll have a higher tax bill in the intervening years. They'll pay about $4,500 in taxes (based on today's tax rates) on their retirement account withdrawals each year. Still, the couple ought to come out ahead, even considering any foregone compound growth on those tax payments, if they live into their 80s.
Is it safe to withdraw more from your retirement accounts?
Some may question the wisdom of withdrawing $67,000 per year from a $1 million portfolio. The 4% rule suggests withdrawing just $40,000 per year, which fits into the plan for the couple claiming Social Security at age 62.
In fact, the couple withdrawing more of their retirement portfolio up front sees more protection from a bad sequence of returns to start retirement. It's already planning to reduce withdrawals later in retirement.
If the net real returns over those eight years come to 0%, the couple who wait to claim Social Security at age 70 would see their withdrawals align closely with the 4% rule starting at age 70.By contrast, the couple claiming early in that scenario would see their withdrawals climb to 5.8% by age 70 if their spending remains the same. The difference stems from the increasing value of Social Security during those eight years, which isn't seen in the portfolio value.
Real life is more complicated
The above is a very simplified example of how the way the IRS calculates taxes on Social Security benefits can have a big effect on your tax bill if you claim those benefits early.
In real life, you may have more wiggle room to keep your combined income low. If you have funds in a Roth IRA, withdrawals from that account won't count toward combined income. If you sell stocks in a taxable account, the principal value doesn't count toward your combined income. And if you end up selling some investments for a loss, you'll be able to deduct at least some of that from your combined income as well.
There are plenty of strategies to employ to reduce your tax bill in retirement if you plan ahead. But claiming Social Security benefits early can limit your ability to plan for taxes long term.
