Avoiding Social Security Taxation with Proper Retirement Planning
Social Security Background Social Security was established in 1935 to alleviate poverty among the elderly during the Great Depression. It was originally established as a self-financing program that would collect payroll taxes from workers which would immediately be paid out in benefits to retirees. Social Security has always been considered a safety net. However, understanding when to take Social Security benefits is challenging for us. This white paper is intended to address some of the basics of Social Security and how to mitigate Social Security taxation for the use of annuities. More than 10,000 baby boomers will turn 65 each day over the next 19 years. As a result, optimizing Social Security benefits has never been more important. When taking time to educate your prospects and clients on Social Security you give yourself the following benefits: Position yourself as an expert on Social Security and retirement. Increase your credibility and trust with new clients. Close more business by showing the value of tax deferred annuities Understanding Social Security and how it integrates into retirement planning provides you the chance to offer added value, help your clients avoid the Social Security tax trap, and actually save them thousands of dollars. Advantages of Social Security Social Security offers a unique combination of several benefits: 1. Steady, Lifetime : Social Security is guaranteed to never run out. Despite fears over the loss of Social Security in the future, it is a certainty that you will be able to assist current clients with understanding Social Security and how taxation works. 2. Predetermined : Using the Administration s mathematical formula, baby boomers can clearly determine their ultimate benefits. The benefit amount is based on earnings history applied to a formula called PIA or Primary Insurance Amount. The longer the individual delays the larger the benefit will be. You or your client can use a publicly available benefits calculator from the Social Security Administration to calculate a fairly accurate estimate of how much will be available to assist in the retirement planning process. 3. Inflation-Adjusted : Every year, Social Security benefits are increased based on a previous year s increase in the Consumer Price Index. This results in a cost-of-living adjustment (COLA) that helps retirees with rising living costs. 4. Spousal and Survivor Benefits: Social Security for married couples opens the opportunity to take advantage of delayed retirement credits in order to collect benefits on the lower earner, while the higher earner s Social Security benefits pool grows over time by approximately 8%. Some of your clients may discover between $20,000 - $40,000 in potentially lost benefits which can be optimized through tax deferred annuities. Even if one spouse dies, Social Security benefits are paid to the spouse and dependents. Benefits Eligibility One becomes eligible by working at a Social-Security covered job for a minimum of 10 years. Technically, one needs 40 credits. One can earn up to 4 credits per year by earning a specific minimum dollar amount. Calculating Benefits Visit www.ssa.gov to access the administration s calculators. Social Security benefits are calculated using a predetermined formula: The amount is determined at 62 years of age Annual earnings are indexed to account for wage inflation 2
The highest 35 years of earnings are tallied (if you work less than 35, missing years count as zero) The 35 years of earnings are totaled and divided by 35 to determine average indexed monthly earnings, or AIME A 3-part formula is applied to AIME to determine the primary insurance amount, or PIA The final PIA calculation is the amount to be received if one applies for benefits at full retirement age (66/67 depending on when you were born). Applying for Benefits The choice of when to receive benefits depends on whether your client needs cash flow or can delay an increase his/her earnings. A general rule of thumb is to delay as long as possible to earn the 8% delayed retirement credits up to age 70 and withdraw benefits at a higher monthly amount. Social Security Taxation Threshold income causes Social Security to be taxed. One s threshold income includes half of Social Security, pensions, IRA Distributions, CDs, money markets, US treasuries, mortgage certificates, capital gains, dividends, tax-free bonds, and corporate bonds. If your client is single, Social Security is taxed when the threshold income exceeds $25,000. From $25,000 to $34,000, up to 50% is taxed. Over $34,000, up to 85% of Social Security is taxed. If your client is married, Social Security is taxed when their threshold income exceeds $32,000. From $32,000 to $44,000, up to 50% is taxed. Over $44,000, up to 85% of Social Security is taxed. How to Address Taxation with Clients According to IRS Publication 1304, 62% of those who are receiving Social Security benefits are paying taxes on those benefits. When your clients discover that not only have they been taxed during their working years but then could be taxed again when receiving their benefits you can channel this frustration into the discussion of proper retirement planing and create tremendous prospecting opportunities. Annuities Protect Against Social Security Taxation Your client s total income, including any interest and investment income, determines the portion of your client s Social Security benefits that are treated as taxable. Amazingly, even tax-free interest on municipal bonds can cause a larger portion of your client s Social Security benefits to be taxable. The strategy to reduce taxation on Social Security benefits is to redirect a portion of your client s assets into a tax-deferred product, such as an annuity, so the interest your client earns on that savings does not count against them when the taxes on Social Security benefits are being computed. Therefore, income credited inside an annuity will not create a tax on Social Security. Tax Limits Owed on Social Security 3 Tax Status Threshold Limit 2011 % Limits Social Security Taxed Single Up to $25,000 0% Between $25,000 and $34,000 50% Above $34,000 85% Married Up to $32,000 0% Between $32,000 $44,000 50% Above $44,000 85% 3
A Case Study: Sarah Senior, Age 72 *Please note that this is a hypothetical example only. Form 1040 Department of the Treasury Internal Revenue Service (99) OMB No. 1545-0074 U.S. Individual Tax Return 2011 IRS Use Only Do not write or staple in this space. For the year Jan. 1 Dec. 31, 2011, or other tax year beginning, 2011, ending, 20 See separate instructions. Your first name and initial Last name Your social security number Sarah Senior If a joint return, spouse s first name and initial Last name Spouse s social security number Home address (number and street). If you have a P.O. box, see instructions. Apt. no. Make sure the SSN(s) above and on line 6c are correct. City, town or post office, state, and ZIP code. If you have a foreign address, also complete spaces below (see instructions). Presidential Election Campaign Foreign country name Foreign province/county Check here if you, or your spouse if filing jointly, want $3 to go to this fund. Checking Foreign postal code a box below will not change your tax or refund. You Spouse Filing Status 1 X Single 4 Head of household (with qualifying person). (See instructions.) If 2 Married filing jointly (even if only one had income) the qualifying person is a child but not your dependent, enter this Check only one 3 Married filing separately. Enter spouse s SSN above child s name here. box. and full name here. 5 Qualifying widow(er) with dependent child Exemptions 6a Yourself. If someone can claim you as a dependent, do not check box 6a..... } Boxes checked X on 6a and 6b b Spouse........................ No. of children c Dependents: (2) Dependent s (3) Dependent s (4) if child under age 17 on 6c who: (1) First name Last name social security number relationship to you qualifying for child tax credit lived with you (see instructions) did not live with you due to divorce or separation (see instructions) If more than four dependents, see instructions and check here Dependents on 6c not entered above Add numbers on d Total number of exemptions claimed................. lines above 7 Wages, salaries, tips, etc. Attach Form(s) W-2............ 7 8a Taxable interest. Attach Schedule B if required............ 8a 20,000 00 b Tax-exempt interest. Do not include on line 8a... 8b Attach Form(s) 9 a Ordinary dividends. Attach Schedule B if required........... 9a W-2 here. Also attach Forms b Qualified dividends........... 9b W-2G and 10 Taxable refunds, credits, or offsets of state and local income taxes...... 10 1099-R if tax 11 Alimony received..................... 11 was withheld. 12 Business income or (loss). Attach Schedule C or C-EZ.......... 12 13 Capital gain or (loss). Attach Schedule D if required. If not required, check here 13 If you did not 14 Other gains or (losses). Attach Form 4797.............. 14 get a W-2, see instructions. 15 a IRA distributions. 15a 2,000 00 b Taxable amount... 15b 2,000 00 16 a Pensions and annuities 16a 18,000 00 b Taxable amount... 16b 18,000 00 17 Rental real estate, royalties, partnerships, S corporations, trusts, etc. Attach Schedule E 17 Enclose, but do 18 Farm income or (loss). Attach Schedule F.............. 18 not attach, any payment. Also, 19 Unemployment compensation................. 19 please use 20 a Social security benefits 20a 10,000 00 b Taxable amount... 20b Form 1040-V. 21 Other income. List type and amount 21 22 Combine the amounts in the far right column for lines 7 through 21. This is your total income 22 23 Educator expenses.......... 23 Adjusted 24 Certain business expenses of reservists, performing artists, and Gross fee-basis government officials. Attach Form 2106 or 2106-EZ 24 25 Health savings account deduction. Attach Form 8889. 25 26 Moving expenses. Attach Form 3903...... 26 27 Deductible part of self-employment tax. Attach Schedule SE. 27 28 Self-employed SEP, SIMPLE, and qualified plans.. 28 29 Self-employed health insurance deduction.... 29 30 Penalty on early withdrawal of savings...... 30 31 a Alimony paid b Recipient s SSN 31a 32 IRA deduction............. 32 33 Student loan interest deduction........ 33 34 Tuition and fees. Attach Form 8917....... 34 35 Domestic production activities deduction. Attach Form 8903 35 36 Add lines 23 through 35................... 36 37 Subtract line 36 from line 22. This is your adjusted gross income..... 37 For Disclosure, Privacy Act, and Paperwork Reduction Act Notice, see separate instructions. Cat. No. 11320B Form 1040 (2011) Filing Status: Single Exemption: Herself Sarah has $500,000 in corporate bonds and she is not spending the interest. Line 8a: Taxable Interest = $20,000 Sarah has a $50,000 IRA and is not spending the interest. Line 15a/b: IRA Distributions = $2,000 (taking required minimum distributions) Sarah lives off this money. (6 in 10 retirees live off their pension and Social Security benefits and view their additional savings as rainy day funds.) Line 16a/b: Pension = $18,000 Line 20a/: Social Security Benefits = $10,000 4
Sarah has $10,000 of Social Security benefits. These may or may not be taxable. The accountant will use this worksheet included in the instructions for Form 1040 to figure the taxable amount of Social Security benefits. The general rule is if this amount adds up to $25,000 or more for a single taxpayer, or $32,000 or more for a married taxpayer, then a portion (up to 85%) of the Social Security benefits are taxable. In Sarah s case, because this calculation added up to $45,000 of countable income, 85% of her Social Security benefits $8,500 are taxable. Summary: going from total income to taxable income Taxable interest $20,000 IRA distributions $2,000 Pension $18,000 Taxable portion of Social Security $8,500 Total income $48,500 Less: Standard deduction $7,250 Exemption $ 3,700 Subtractions from income $10,950 Taxable income $37,550 Let s calculate Sarah s Tax: Here is how it works for Sarah s situation. Add up: Half of Sarah s Social Security income $5,000 Plus ALL of her other income: Taxable interest $20,000 IRA distributions $2,000 Pensions $18,000 Total $45,000 We would need to add otherwise tax-exempt interest, such as interest on municipal bonds to this calculation if Sarah had any. SINGLE Tax Rate $0 - $8,500 10% $8,501 - $34,000 15% $34,501 - $83,600 25% $83,601-174,400 28% $174,401 - $379,150 33% Over $379,150 35% Tax Rate Tax $ $8,500 10% $850 $26,000 15% $3,900 3,050 25% $762.50 $37,550 35% $5,512.50 5