Tax Rate Roulette

Back in February, I wrote in my blog post titled “Retirement Income” that I recommend that people wait until at least Full Retirement Age (FRA) to file for Social Security rather than file at age 62 when you are first eligible. While this wasn’t the main point of that blog, the point does reflect my position. If you can wait until FRA and you don’t have extenuating circumstances such as poor health, you should wait to file because your benefits increase by about 8% per year for every year that you wait.

Reader Response

A reader responded to that post with a good question: What if you file for Social Security at 62, use that money to pay bills and live on, and instead refrain from drawing on your IRA/401K and allow those accounts to continue to grow tax-deferred at perhaps 6% to 8% per year? Wouldn’t you be better off then instead of waiting to draw your Social Security at FRA?

Tax Rate Roulette

My first thought is it doesn’t matter at one level. If you are in the situation such that you need to draw either Social Security or your IRA to pay your bills and both offer an 8% tax-deferred return by not drawing, then it doesn’t matter whether you draw from Social Security or your IRA. Both are taxable income to you, but if you are in the situation that you need to draw to pay bills, then you likely aren’t paying a lot of taxes. However, while it is pretty certain that your Social Security benefits will grow 8% per year, it is not at all certain that your IRA will, and some years will be better than others. On balance, I say draw the IRA before Social Security.

On another level, the answer depends on tax rates. Do you think tax rates in the future will be higher than tax rates today? Especially now that the Government has pumped an additional $3 Trillion into the economy, thereby adding to the deficit? If you believe tax rates are going up, and you have income out there to draw now vs. draw later, then it makes sense to draw more now at a lower tax rate than to save it and draw later at a higher tax rate. Since your Social Security benefit is fixed and your IRA draw is up to you (until you reach age 70.5), then you can opt to draw more of your IRA now and save your Social Security until later and perhaps save on your lifetime tax bill. There are so many variables in this equation that it is not an apples-to-apples conversation, but all things being equal (which they admittedly are not), then paying a lower tax rate now may be the better alternative for you. Then again, the equation changes if you have other sources of income that can tide you over such that you needn’t draw on either Social Security or your IRA until you truly retire.

Slott

Regarding the tax rate now vs. tax rate later argument, I am quoting Ed Slott, regarded as one of this country’s foremost IRA experts and who I have heard speak in person. I recommend you look at Ed’s website, irahelp.com. He has lots of great information about strategies regarding when to draw on your IRA. There are free sections and paid sections to Ed’s website – don’t pay unless you are really into the subject. Ed’s is the best website I have seen about this topic and I highly recommend it.

IMO

Everyone’s situation is different. Here I am providing you a big-picture way to analyze and make this decision using projected rates of return and tax rates. You can use that as a framework but your own specifics will dictate the decision. My ask: If you are facing this decision and aren’t clear how to analyze it or as to which factors are important and which are not, please contact me to help sort through the situation. Yes I charge a fee but hopefully you will make a better decision.

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