The Domino Effect of Your Retirement Decisions: How Social Security, IRA, Income, and Taxes Are All Connected

I’m going to show you today what I believe is the least understood aspect of retirement planning and the most consequential. Not understanding the flow and sequence of these decisions could cost you hundreds of thousands of dollars in your retirement.

In our other videos where we do the case studies, “I’m 60 with 1.5 million, you’re 62 with 2 million, you’re 60 with 800,000.” Those case study videos, if you want to understand this more deeply, those are for you. Today, high level, concise, straight to the point, I’m going to tell you the relationship that these decisions can have on your income, your taxes, and your account balance in your retirement.

The 4 Big Pillars of Retirement: Social Security, Income, IRA Withdrawals, and Taxes

These are the big four elements of retirement planning. When do you take Social Security? It can be well over a million dollars of income for you. For most of you, it’ll probably be 1.5 to 2 million if you’re married.

How much income? Where do you take that income from? Your IRA balances, because your retirement accounts, they’re tax-infested accounts. Every time you take money out, you have to pay income taxes. You’re forced to start taking money out at age 73 or 75, depending on when you were born. Then the amount of taxes that you pay. There’s a domino effect. When you take Social Security impacts your income today, but also your income in the future. When you take Social Security impacts your income, and therefore it impacts your retirement account balances.

If you’re taking Social Security, you have to take less out of these. They grow to a higher amount. If they grow to a higher amount, in the future, you’re going to pay a lot more in taxes because you’re forced to distribute money from those accounts. I don’t have health care up here or estate planning. Those are important, and those are interrelated. They’re part of the income and the balances section, because if you have less income later or more income later, that’s what you have to pay for health care expenses. IRA balances, taxes, have to do with the estate planning side of things. These are really the drivers of everything else in retirement.

When you take Social Security determines how much income you have, determines how much balance you have in your retirement accounts, which then impacts the taxes that you pay.

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A Real-Life Example: Married Couple, Age 65, Exploring Two Different Strategies

Here we have a high-level case study with the goal of communicating the concepts, the things that you need to understand about the relationship between all the decisions that you have to make. Not going into a tremendous amount of detail here because I don’t want to get bogged down in the details. I don’t want you to get bogged down in the details. I want you to focus on the concepts.

In the case study, we have a married couple, both 65 years old, retiring now. In one situation, they’re going to take Social Security as they retire. In the other, they’re not. They’re going to defer until age 70. Now, one scenario, the one where they take Social Security early, they are not going to do any Roth conversions. They’re going to let those retirement accounts defer and then pull from the non-IRAs. In the other, it’s going to be a more strategic Roth conversion approach. Both scenarios are spending $80,000 a year, and both scenarios have about $1.3 million in assets, most in retirement accounts.

The only thing we’re changing here is when Social Security is elected and the tax decision to move money from an IRA to a Roth IRA. Now, I want to be clear. This is not a Roth conversion video. I’m not urging you to do a Roth conversion. I’m simply focusing on the decisions that you have to make and the interrelationship that they have with other aspects of your retirement plan.

Side-by-Side Account Balance Projections Over Time

We’re going to start in ledger style so we can very easily see the comparative analysis. Over here, the base strategy, we’re taking Social Security at retirement. Over here, we are not. We are not doing Roth conversions here. We are over here.

Not only are we doing Roth conversions, but we’re doing what we call a multi-account distribution strategy, where the income that we need is coming from multiple different places, along with Roth conversions, to target a specific tax bracket that allows us to optimize our entire retirement strategy. Distribution is the big variable here, and Social Security. First thing I want to focus on, age 73, we took it at 65, $73,000 combined Social Security. Whereas over here, we deferred Social Security, both spouses, until age 70. Now we’re up to $100,000, $103,000 a year. 103, 100, somewhere in that range, you see these. That’s an extra $30,000 a year of retirement income by simply deferring.

Now, I’m not telling you to defer Social Security. Many of you, it makes sense to take it early. What I am showing you is the difference between the decision and how that dominoes into other aspects of your retirement plan. Here we took it early. We don’t pay any taxes. I’m going to show you how Social Security is taxed and how this is possible. More importantly, the impact you’ll see over here is really going to open your eyes to some of the preferential tax treatment of your Social Security income.

We take Social Security early, which means we have to take less from our account. Our account balances will actually grow because we’re getting most of our income from Social Security. We look here, let’s go 73, the same age, $1.8 million before tax balance. This is before the tax is calculated for your retirement accounts. We’ll just focus on this one, $1.8 versus $1.3. Taking Social Security early means we have more income sooner, less income later. We pay less taxes now, more taxes later, but we have higher account balances.

Over here, no Social Security, more income later, less taxes later, more taxes now, and smaller account balances. Now, we’re going to go down to age 80 just to see how big the difference really becomes in some areas. Some areas, it’ll get closer. Age 80, Social Security is $86,000 versus $120,000. Taxes are $17,000 versus $1,400. $1,400 in taxes on $119,000 of Social Security. Balances of 2.3 versus 2.1. The gap has narrowed between the account balances.

One of the primary drivers of that is the higher Social Security income causes you to take less money out of your accounts later in life. Not to mention, you’re paying less taxes. The tax distribution is a smaller percentage of everything, so you have more money in your accounts. This conveys the domino effect. Simply taking Social Security, it impacted your income then, your income later, your taxes then, your taxes later, your account balances in both scenarios. It can also flow through to many other aspects. Your Medicare premiums, your net investment income taxes, plenty of other areas of your retirement. I’m just focusing on these big pillars that we initially started talking about.

Line and Bar Charts Reveal How Each Strategy Affects Wealth, Taxes, and RMDs

Here we have some charts to help visualize this a bit better. We have the blue line is the conventional wisdom path, where we’re taking Social Security early, deferring those retirement accounts. The green is what we looked at over here on this ledger. We can see clearly the account balances. This is what we have on the y-axis. The account balances are less in the beginning, and they gradually catch up and surpass the first scenario. Total taxes, the green, again, was this side of the ledger. We’re paying more taxes early versus later. We can clearly see the two different paths that those decisions made on what our retirement looks like.

Here’s a big one, required minimum distributions. Again, the green versus the blue. The simple decision of when to take Social Security and whether or not we’re doing those Roth conversions has completely changed what our retirement looks like. The blue shows us that we have required distribution starting at 75 of $73,000, $100,000. This is why you get into a state of what I call permanent taxation, and you’re carrying more tax risk because we do not know what tax rates will be in the future. We do know that retirement accounts, IRAs, 401ks, if that tax problem is not addressed, you will have taxable income in the future.

The government’s not always all of a sudden going to say, “Hey, those IRA balances, those 401ks, you don’t have to pay us taxes on those. We were just kidding all along.” We do know that that will be subject to income tax. We just don’t know how much. The green down here is the Roth IRA scenario, where obviously we have much smaller required minimum distributions because you’re not forced to distribute. Those decisions, when to take Social Security and whether or not you’re doing Roth conversions, has had this domino effect that has cascaded into two entirely different retirement lifestyles, retirement scenarios, and these help you visualize that.

Last visual chart here is the account composition. This is where the legacy comes in for those of you who want to give money to your kids and grandkids, and you want to optimize what you leave them. The base strategy here, again, this is what was the left-hand ledger that we started with. The blue represents tax-deferred, so IRAs. We can see clearly, yes, we’re not worried about running out of money. Our account balances are actually increasing over time. What’s happening is your money is staying in these tax-infested accounts. Not saying that’s good or bad, just it is what it is.

How Your Account Composition Affects What You Leave Behind

Over here was the ledger that we had on the right-hand side. Now we visualize what the composition of our accounts looks like, because the gold is now tax-free. The blue is tax-deferred. Again, the decisions that we made earlier not only have impacted our income, our account balances, our taxes, but of course they’ve impacted our account composition, which then impacts how much money our kids and grandkids actually get to keep. In this scenario, let’s say you pass on $1.7 million of tax-infested retirement account money, the kids can let it grow for up to 10 years, but then they have to fully distribute it.

Let’s say they don’t need it. They have good jobs. The 1.7 grows to 3.4, 7% or so interest rate over 10 years. The IRS says you have to distribute this money now. That 3.4, all of it has to come out, and they have to pay taxes at whatever the top federal marginal tax rate is in the future. Right now it’s 37%. Very well, it could be 39, 40, 42, 50. It’s up for you to decide if you think taxes will be higher in the future. If they also live in a state like California or New York or Massachusetts or New Jersey, or somewhere where there’s a high state income tax, not only are they going to pay the top federal rate, but they’re going to pay, most likely, the top state rate.

Now you’re really getting into 45, 50, 55, possibly 60, 65%, depending on what federal and state taxes are in the future. Again, it’s not good or bad, right or wrong. This is the decisions that you’re making, how they impact everything else in retirement. It’s all interrelated. It’s that domino concept. The purpose of this video is to help you visualize what those decisions or the impact that those decisions have on the grander retirement picture.

Something exciting to announce here. We’re going to start bringing on three advisors here at Oak Harvest Financial Group, Ed Rossi, Nicole Riney, and Janice Whitten, and they’re going to tackle specific areas of retirement planning with their own content that we’re going to be distributing here on the channel. Ed is going to focus on Social Security. Hopefully I’m not taking too much of his thunder here, but I think this is pertinent for this video so you can start to understand how you can have so much Social Security income and pay such little tax.

Understanding the Complex Formula Behind Social Security Taxation

Social Security taxation is very complex. I’m going to try to make this as simple as possible. There’s a concept called provisional income. What this is, is your Social Security benefits cut in half. You take 50% of your Social Security benefits, reduce it by half, multiply by 50%. That $40,000 is what’s called your provisional income. That provisional income gets added to any other sources of income that you have in retirement. In this example, we don’t have any other sources of income because, one, we’ve either converted to Roth, and that’s where we’re taking our income from, or we don’t have any other sources of income.

Just focusing on Social Security taxation. You start with 80,000, you cut it in half, that’s 40,000, you then add that to any other income that you have, including tax-free income from municipal bonds. You would add your municipal bond income on top of this provisional income. It gets you to something called modified adjusted gross income. For now, let’s assume that this is all we have. 80,000 of Social Security, our provisional income would be 40,000. That 40,000 now becomes what is our taxable income. That taxable income, you then apply your standard deduction.

If you’re a married couple over 65, your standard deduction right now is 32,300. You take that deduction from your taxable income, and it leaves you with $7,700 of taxable income. That $40,000 is your provisional income. Now, this assumes you don’t have other sources of income because we’re focusing on how Social Security is taxed. If you did have other sources of income, you would now take this 40,000 and add it onto your other income. Let’s say you had $10,000 of other income. Let’s say it’s a pension check. You would now have $50,000.

Also, municipal bond income actually gets added back into this. Even though it’s income tax-free federally, you would add your muni bond income on top of this provisional income, and all of this. Your provisional, which is 40,000, plus your muni bond income, plus any other sources of income, it adds up. Now, that is what’s called your modified adjusted gross income. You take that modified adjusted gross income, you subtract your standard deduction. If you are over the age of 65, probably are if taking Social Security or pretty close, you’re now left with $7,700, which is your taxable income.

With $80,000 of Social Security and only $7,700 of taxable income, you’re not paying a lot of taxes. That’s why Social Security is a preferentially treated source of income in retirement from a taxation standpoint. That’s why you can get your taxes really low if you’re understanding the relationship between these different aspects of retirement planning and how the decisions that you make domino into not just the now, but of course, the later.

Everything’s Connected: Why Retirement Planning Requires a Look at Sequence

Hopefully, we were able to convey some very important concepts that you did not understand, and now you understand much more clearly. If you want help with any of this, feel free to reach out. We’re always here on the retirement planning side. This is what we do. Any comments that you want to leave, maybe we can address them in a future video, but I’d love to hear if you understood all this or if you didn’t understand this and how hopefully the light is much clearer, the visibility you have into the decisions that you’re making is much better. That’s why we do these videos. Thank you very much.

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