Spend Your IRA First – Maximize Your Social Security

Ask almost any financial planner if you should spend your IRA first or last and you will be told to spend your non-qualified (after tax) savings first and your qualified (IRA, 401K, 403B) funds last. Recent research has shown this is not necessarily the best way to use your retirement funds. For the sake of brevity, we will refer to the qualified plans as IRA in the rest of this article.

Most retirees will receive their retirement income from a combination of their non-qualified savings, their IRA, and from Social Security and/or a pension. Income tax must be paid on the funds coming from the IRA, Social Security, and the pension. You were already taxed on the principle of your non-qualified savings so only the dividends, capital gains, and interest will be taxable on them. The dividends and capital gains receive lower taxation than your normal tax bracket.

One reason to spend your IRA first is to use it to delay taking Social Security until age 70. This will increase your Social Security benefit by approximately 162% over taking it at age 62 and by approximately 135% over taking it at age 66.

By maximizing your Social Security benefit at age 70, you are taking advantage of a monthly income stream guaranteed by the United States Government that is adjusted for inflation. Where else can you find income of that quality in the financial markets?

Inflation has to be a concern of retirees since it can substantially erode retirement savings. By maximizing the amount of your Social Security benefit, you are minimizing your exposure to future inflation.

If you read the current financial press, many writers are predicting inflation to increase in the future. Even now with the increase in oil prices, food prices, and prices of other items, we are seeing a short term increase in inflation. If inflation continues to rise in the future, you need to have a plan to minimize its impact on your retirement. Social Security will shield that part of your income from inflation so maximize your Social Security benefit.

Another reason to spend your IRA first is to save taxes during your retirement and give you more after tax income to enjoy in your retirement.

Every dollar of your IRA is taxable when you withdraw it. You were allowed to deposit it into the IRA tax-free, but now is the time to pay Uncle Sam. The concept is that you put the funds in the IRA when you were working and in a high tax bracket so you could withdraw them in retirement when you were in a lower tax bracket.

What if taxes are increased? This will increase the tax you pay on your IRA withdrawals. Unfortunately, it appears taxes will increase during your retirement to support Social Security, Medicare, War on Terror, and other government programs.

Spending your IRA first can also lower the amount of tax you have to pay on your Social Security benefits. This will be covered in detail in another article.

In summary, spending your IRA first can increase your Social Security benefits, lower your tax exposure from potential tax increases in the future, and lower the tax you pay on your Social Security income.

PART II

Previously, we explored why it was best to spend your IRA first. The first reason was to delay taking Social Security until age 70 to maximize the inflation adjusted income from a safe source, the United States Government.

The second reason was to have the IRA withdrawals taxed under the current tax structure since it is highly probable that tax rates will rise in the future. If you delay your IRA withdrawals, they may be taxed at a higher rate.
The third reason that was not covered in detail in the previous article is to reduce the amount of money that you will have to pay on your Social Security benefit income. We will cover this reason in detail in this article.
It may come as a nasty surprise to retirees that income tax must be paid on Social Security benefits if what the Internal Revenue Service calls your “provisional income” is over a certain limit. Provisional income is figured by summing your adjusted gross income, your tax-exempt income, and one-half of your Social Security income.
The more income you receive, the larger your provisional income will be, and the more tax you will pay on your Social Security benefits
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If you are married and your provisional annual income is over $44,000, you will be in the higher tier of provisional income and you could pay tax on up to 85% of your Social Security.

When you spend your IRA first and maximize your Social Security income, you will draw less from your IRA since more of your retirement income will come from your Social Security. This lowers your adjusted gross income which in turn lowers your provisional income. Lower provisional income lowers your taxes on Social Security. This gives you more after tax income to enjoy in your retirement.

Let’s take the case of two married couples who file jointly. They plan for $70,000 per year retirement income. For sake of simplicity, let’s assume that both couples have the same Social Security benefits at their normal retirement age and both have the same amounts in their IRA’s.

Couple #1 starts taking Social Security at age 62 and receives $30,000 annual Social Security benefits.
Couple #2 spends from their IRA’s first to delay taking Social Security. At age 70, they start receiving Social Security benefits of $48,600 per year.

At age 70, the pretax income for each couple will be:
Couple #1 $40,000 from IRA’s plus $30,000 Social Security = $70,000
Couple #2 $21,400 from IRA’s plus $48,600 Social Security = $70,000
If you want to skip the final tax calculations, skip down to the heading “Final Tax Amount” to see the tax savings from spending your IRA first.

Calculation of Provisional Income
For the calculation of provisional income we will assume that they did not receive any tax exempt interest.
Couple #1 $40,000 from IRA’s plus $30,000/2 Social Security = $55,000 provisional income.
Couple #2 $21,400 from IRA’s plus $48,600/2 Social Security = $45,700 provisional income.
As you can see, by spending their IRA funds and delaying Social Security, couple #2 lowered their provisional income by $9,300.

Calculation of Taxable Social Security Income
How much does that save in taxes? The IRS has made this calculation complicated. You can access the form for this calculation on page 25 of the Instructions for Form 1040 from the IRS website.
Since these couples will be over the upper limit ($44,000) for provisional income, the amount they will pay on Social Security income is calculated by performing two calculations and then taking the lesser of the two amounts from the calculations.
Calculation #1 = 85% of Social Security
Calculation #2 = $6,000 %2B 85% times (provisional income – $44,000)

For couple #1
The first calculation is 85% times $30,000 Social Security = $25,500.
The second calculation is $6,000 plus 85% times ($55,000 less $44,000) = $15,350.
The lesser amount from the two calculations is $15,350.

For couple #2
The first calculation is 85% times $48,600 Social Security = $41,310.
The second calculation is $6,000 plus 85% times ($45,700 less $44,000) = $7,445.
The lesser amount from the two calculations is $7,445.

Final Tax Amount
Now let’s calculate the total taxable income for both couples.
Taxable income for couple #1 will be total IRA income ($40,000) plus the taxable Social Security income ($15, 350) = $55,350.
Taxable income for couple #2 will be total IRA income ($21,400) plus the taxable Social Security income ($7,445) = $28,845.

To calculate the tax each will pay, we will use the 15% tax rate.
Couple #1 will pay $8,303 and couple #2 will pay $4,327. Couple #2 will save $3,976 in taxes over couple #1.
By spending their IRA first, couple #2 will have $3,976 more each year to spend on their retirement. Multiply this over the years in your retirement and it will take you on a few nice trips or allow you some pleasures that you would otherwise not have been able to enjoy.

In summary, spending your IRA first can increase your Social Security benefits, lower your tax exposure from potential tax increases in the future, and lower the tax you must pay on your Social Security.

Disclaimer: The information in this article is general information. If you want to leave an estate to your children or if you are in poor health, concepts presented in this article may not apply to you. Seek professional advice from your accountant or a professional adviser.

Article by John Howe