SOCIAL SECURITY

Social Security is an important part of the Old-Age, Survivors, and Disability Insurance (OASDI) program. This is a social welfare and insurance plan managed by the U.S. federal government that pays benefits to retirees, as well as to workers who become disabled and to survivors of deceased workers. Social Security's benefits include retirement income, disability income, Medicare and Medicaid, and death and survivorship benefits. Social Security is one of the largest government programs in the world, paying out hundreds of billions of dollars per year.

Based on the year someone was born, retirement benefits may begin as early as age 62 and as late as age 70. The amount of income received is based on "average indexed monthly earnings" during the 35 years in which you earned the most. Spouses are also eligible to receive Social Security benefits, even if they have limited or non-existent work histories. A divorced spouse can also receive spousal benefits, if the marriage lasted 10 years or longer.

1.    PROVISIONAL INCOME AND TAXATION OF SOCIAL SECURITY BENEFITS

To understand why our Social Security gets taxed, it's important to understand Provisional Income. Provisional income includes all of the following:

•       All earned income.

•        Distributions from Qualified Plans (IRAs, 401Ks, etc.).

•        Required Minimum Distributions (RMDs).

•        1099 income.

•        Pension income.

•        Rental income.

•        Interest from Municipal Bonds.

•        One-half of your Social Security income.

The IRS adds up all of your Provisional Income and, based on that total, and your marital status, determines what percentage of your Social Security benefits will become taxed. That percentage of your Social Security is then taxed at your highest marginal tax rate.

Example of Social Security Taxation

Bob and Mary's Provisional Income is as follows:

• Pension: $50,000 per year

• Required Minimum Distributions: $20,000 per year

• 1/2 of Social Security: $15,000 per year Total Provisional Income: $85,000

Because Bob and Mary breached the $44,000 threshold, 85% of their Social Security became taxable at their highest marginal tax bracket.

Assuming a 25% federal tax rate (Most states do not charge state tax for Social Security), and assuming a Social Security benefit of $30,000, then 85% of that amount would be subject to taxation. 85% of $30,000 is $25,500. When we multiply $25,500 by 25%, we find that Bob and Mary's total Social Security tax bill is $6,375 per year!

Because of Social Security taxation, Bob and Mary experienced the following:

• Lost $6,375 in yearly Social Security benefits

• To compensate, they would likely have taken distributions from their IRA

• At 30% tax rates, this totals $9,107

• Total cost of Social Security Taxation = $9,107 per year!

The Long-Term Costs of Social Security Taxation

• The damage doesn't stop here. Bob and Mary not only lost $9,107 because of Social Security taxation, they lost what it could have earned for them had they been able to keep it and invest it over the balance of their retirement.

• If Bob and Mary had been able to keep that $9,107 every year and invest it at 8% over the next 20 years, how much better off could they be? $450,094 better off! So, the total cost of Social Security taxation can take a huge toll on one's retirement over time.

2. AVOIDING SOCIAL SECURITY TAXATION

Given the realities of Provisional Income, is there any possible way to avoid Social Security taxation? The key is to keep your Provisional Income below the thresholds which cause Social Security to be taxed.

This can be done by repositioning a portion of your assets into vehicles that do not count as Provisional Income, such that your remaining streams of income keep you below these thresholds. By accumulating the right amounts of money in the right types of vehicles, you can reduce your Provisional Income to acceptable levels and keep your Social Security free from tax!

Ensure that Your Provisional Income Stays Below Thresholds

The following vehicles do not count as Provisional Income:

•        Roth IRAs.

•        Roth 401ks.

•        Roth Conversions.

•        Permanent Life Insurance, such as Indexed Universal Life.