How Social Security Coordination Can Add Value to a Tax-Efficient Withdrawal Strategy

Abstract

This study describes a tax-efficient withdrawal strategy that can add substantial value to many clients of financial advisors with financial portfolios worth up to $2 million. In early retirement years, these households can delay the start of their Social Security benefits and make Roth conversions to fill relatively low tax brackets, which are generally also their marginal tax rates. Once Social Security benefits begin, they can make tax-free Roth withdrawals to minimize the amount of tax-deferred account (e.g., 401(k)) withdrawals that are taxed at 185% of their tax bracket, due to the taxation of Social Security benefits. With a series of cases, we show that a financial advisor can add substantial value to many of their clients’ financial portfolios by recommending such a withdrawal strategy.

Key Findings

• • Due to the taxation of Social Security benefits, there is a wide range of income where a household will have a marginal tax rate of 150% or 185% of their tax bracket, where marginal tax rate denotes the additional taxes paid on the next dollar of income.

• • This study presents a general tax-efficient withdrawal strategy that will help many singles and married couples with financial portfolios worth up to $2 million substantially reduce the present value of their lifetime income taxes. In addition, these withdrawal strategies can greatly reduce the percentage of these households’ lifetime Social Security benefits that will be taxable.

• • In the general tax-efficient withdrawal strategies, in early retirement years, these households should delay the start of their Social Security benefits and make Roth conversions to fill relatively low tax brackets, which are generally also their marginal tax rates. Once Social Security benefits begin, they can make tax-free Roth withdrawals to minimize the amount of tax-deferred account (e.g., 401(k)) withdrawals that are taxed at 185% of their tax bracket, due to the taxation of Social Security benefits.