The Hidden Tax Impact of Social Security & Other Income Sources in Retirement

Electing to take Social Security is a massive decision for anyone in retirement, no matter how much money you have. If you do the math, many of you will receive over $1 million from Social Security over the course of your retirement. For some of you, it may be 2 million, 2.5, possibly even $3 million if both spouses worked and you live in extended retirement into your 90s. It’s a big decision. We often talk about the domino effect of the various decisions that you have to make in retirement. Where do you withdraw your income from, the IRAs, the non-IRAs? When do you take Social Security? Do I do Roth conversions? What are my investments? What are the dividends I’m generating? The interest income, short-term, long term capital gains.

All of these different aspects of income and tax planning are like dominoes. Not only do they affect your taxes and your amount of income, but of course they impact your account balances.

What you’re going to learn in today’s video is how your taxes are impacted by not only electing Social Security but having other sources of income. If you’ve watched this channel for some time, you’ve heard me talk about this net concept. It’s very simple. The Internal Revenue Code, the IRS, it’s like a net. Whenever you take income from a certain place, it has the potential to drag, like a net, other sources of income into a state of taxation from one that they previously were not taxed. You’ll hopefully see that today as I go through the example on the screen here and hopefully, apply it to your retirement to make some better decisions or at least have a better understanding of the impact your decisions are making.

Example of Couple Receiving $50k in Social Security Income

Our base case for today’s analysis will be a married couple receiving $50,000 of Social Security income. Now if you’re single, these concepts still apply. The thresholds are just different for single versus married filing jointly. The base case is going to be over here. This is $50,000 of combined Social Security income married filing jointly. Then as I go through the different columns, we’re going to layer on additional sources of income from various places. We’re going to hopefully communicate to you how the Internal Revenue Code operates when it comes to dragging your Social Security as well as other sources of those income into a state of taxation from a state of being tax-free.

Okay, so our base case here, we don’t have any other sources of income. This is a tax planning tool that we use to help identify what are some of the most optimal ways to take income, what’s the impact on your overall taxes if you’re going to make a certain decision versus another. That’s what some of these lines are for. We see gross Social Security. This is our base case. That’s receiving $50,000 of Social Security income, husband and wife. Taxable amount of that Social Security is zero. Remember I said Social Security is a preferentially treated source of income. This is on paper mathematically showing you what I mean.

You have $50,000 of Social Security income and zero is subject to income taxes. If we scroll down here to see the actual amount of total tax due, it’s zero.

The Effect of Adding Dividends to Social Security

For the second scenario, we’re going to add some dividends on top of the Social Security income. An important point about dividends here, and these are in what we call a non-qualified account because if they were in your IRA, those dividends would simply be reinvested and you would not be taxed unless they were distributed out of the IRA. Technically, you could take those dividends and put them into a cash bucket inside that IRA. Point being here, these are non-qualified dividends in the sense that they are outside of a retirement account.

Now if that was confusing, this is probably going to be more confusing as well because there is something called qualified and non-qualified dividends. First concept, qualified account, non-qualified account, IRA, non-IRA. Qualified dividend versus non-qualified dividend is same word but different concept. A qualified dividend is taxed at the more preferential dividend and long-term capital gain tax rates. In order to be a qualified dividend, there are a few caveats that you have to hit, but the one most important is you have to hold the dividend for 60 days within a 120-day window around the ex-dividend date.

If you Google it, look it up, you’ll get the exact definition, but that’s approximately what it is. Now, non-qualified dividends, if you own a dividend for a shorter period of time than that period, they are taxed at income tax rates. Your income tax rate may be 10%, it may be 22%, it may be 24%, it may be higher. Dividend tax rates are either 0%, 15%, technically 18.8%, 20%, or 23.8%, but you have some crossover there. The 18.8% and the 23.8%, that’s from a surcharge from the Affordable Care Act that goes onto your investment income.

A little bit off-topic there, but I know many of you may have questions, so I wanted to provide a little bit of additional context in case you do your own research after watching the video. Qualified account, non-qualified account, IRA, non-IRA. Qualified dividend, non-qualified dividend, qualified dividend taxed at preferential rates, non-qualified dividend taxed at income tax rates. You can see this on your tax return. It actually looks like this. You’ll see total dividends, which is inclusive of your qualified dividends. Typically, this is always going to be higher. If you do any buying or selling, if you own a dividend portfolio for many years, they’re probably all qualified dividends, or quite possibly, unless you reinvest it and acquire some new shares.

The point being, that’s what your tax return will look like if you go to the first page of your 1040. That’s why I’m showing you this here because I’m trying to make it a little bit more realistic. We have $25,000 in total dividends, of which 20,000 are qualified dividends. We still have the Social Security of $50,000. All I’ve done is added $25,000 of dividend. I’ve layered on another source of income on top of Social Security. Just like that net, what we’ve done by having this income is we’ve dragged from zero of the Social Security being taxable, we’ve now dragged $11,100 of your Social Security income into a state of taxation. No other sources of income.

Now, our total income from a tax standpoint is $36,100. That is our AGI, just a gross income. Married couple over the age of 65 has a standard deduction, $20, 25 of $33,200. Taxable income is $2,900. The most important number, your total tax is still zero. Here we have $25,000 of dividends for your retirement income, along with $50,000 of Social Security income. You’re still paying zero taxes as a married filing jointly couple. Okay, now I want to show you something pretty cool that we use from a tax planning standpoint.

Taking Additional Income Taxed at Ordinary Income Rates

If you’re not following all this, don’t worry. I want you just to understand the concepts of when you take additional sources of income, it can drag other sources of existing income from a state of tax-free into a state of taxation. Now, this is a pretty cool tool that we use. Depending on where your income is, it’s going to line up differently on this chart, meaning where you’re taking your income from, what sources. What this chart is showing us is the tax impact on the next $1,000 in ordinary income. If you have $1,000 of income from a source that is taxed at ordinary income rates, so IRA withdrawals, bond interests that are not municipal bonds, non-qualified dividends, Roth conversion, anything that’s taxed at ordinary income status, what this chart is showing us is how it impacts your overall taxes.

From a planning standpoint, I know that I could take another $9,000 in ordinary income, in income from a source that’s taxed at ordinary income tax rates, and there would be zero taxation across the board on Social Security and dividends. Once I get here and I start taking $10,000, now my effective total federal income tax rate jumps to 14%. That’s comprised of an additional taxation on Social Security, as you can see, at 6.4%, and additional tax on ordinary income at 7.6%. What that essentially means is those two now have gone from a state of not being taxed into a state of taxation.

Then as we go through here without spending too much time and getting bogged down, we can see as we take more and more dollars from ordinary income sources, tax rates jump. Now we’re up to 22.2% on the federal income tax, but it’s only because we’ve brought more Social Security into a state of taxation and more taxes on our already existing ordinary income. When we get here now, it all drops. At this level, if we take another $40,000, you can see at the bottom there $40,000 of income from a taxable, from an ordinary income source, we’ve already dragged in everything prior to this level that we possibly can.

Now we’re just being taxed at 12% on these next dollars withdrawn from the accounts. Once we get to this point, if we withdraw $63,000 more, now we’ve jumped up to 21%, and now here even 27%. This is what we call the tax torpedo. I know it may not be easy to understand. Heck, this took me many, really, years to fully grasp the concept. I just want to point out what we mean when we say taking income from certain places drags other sources of income into a state of higher taxation many times.

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Adding Long-Term Capital Gains to the Mix

Now, for scenario three, I’m going to layer in long-term capital gains. We have Social Security as the baseline, scenario one. We added some dividends for scenario two on top of the existing Social Security. Now we’re going to add long-term capital gains because long-term capital gains, again, are tax preferentially, that’s compared to short-term capital gains. If you sell something within a year of owning it, those gains would be taxed at ordinary income tax rates. That’s the chart that we just went through. That chart would be impacted, and your taxes would go higher, possibly bringing Social Security and other dividends into taxation.

Dividends here, we have the Social Security. What I’ve done is I’ve simply added $20,000 of long-term gains. Now, apply this conceptually to your retirement. You’re retired, you’ve turned on your Social Security, and you want to go on vacation. You have some choices. Do you take it from your IRA? Do you take it from long-term capital gain assets? Do you take it from short-term capital gain assets? Where do you take it from? This is what I’m trying to communicate is how those decisions that you have to make, how they impact how everything else is impacted, for lack of a better word. We’ve added $20,000 of long-term capital gains.

Now, everything we have here, what we’ve done is we’ve brought Social Security into a greater state of taxation by simply adding this capital gain on. Previously, without the capital gain, $11,100 of Social Security was taxed. Now, we’ve brought $17,000 more of our gross Social Security into a state of taxation. Now that is subject to tax. That’s all I’ve added. Our total income jumps to $73,000, our adjusted gross income. Think about this. This may help you grasp this concept. All we did in this scenario was add $20,000 from long-term capital gains to previously existing circumstances. It’s changed our adjusted gross income by $37,000.

My math is correct there. We’ve only added $20,000, but it’s gone up $37,000. Now, from a tax standpoint, we still get the same standard deduction here. Look at this. Total tax is still $0. Now, you might be a little bit shocked. Okay, Troy, we have this Social Security. You’re saying more is being dragged into a state of taxation. We have the dividends. We have the long-term capital gains. Why is there not any tax? It’s all accumulating here. Remember, long-term capital gains are taxed preferentially. Qualified dividends are taxed preferentially. Social Security is taxed preferentially.

We have all of these sources of preferentially taxed income, even though we’re up to, I want to say, $100,000 or $73,000 of total income. We’re still paying $0 in total taxes. Okay, if you’re following along this far, that means hopefully you’re either understanding the concepts or you’re really interested in tax planning for retirement. Either way, I now have a pop quiz for you.

If you look at the last chart that we put up before I added the long-term capital gain there, I showed you that if we take, I think it was another $9,000 of ordinary income, we would exhaust our tax-free income. Once we got to $10,000, we would start to bring things into a state of taxation. My question is, the pop quiz, why, when I take $20,000 of long-term capital gains, did I not exceed that $9,000 threshold and bring things into a state of taxation? Because it was still 0% tax on that extra income that I brought in.

Okay, as a refresher, here’s the chart that I was just referencing. We said, if we have another $9,000 of income here, that is the most income that we can take without bringing Social Security and dividends into a state of taxation. We took a $20,000 long-term capital gain. Why are the taxes still 0%? It’s because this is ordinary income. If we actually look down here at how long-term capital gains are taxed, so there’s two different tax systems, and they work interconnectedly. They are also separate, meaning we actually could take, from a capital gains standpoint, and this just happens to be happenstance, up to $20,000 of long-term capital gains before we bring any other sources of income into a state of taxation.

If I would have taken $22,000 in long-term capital gains, now I’m bringing a total tax rate of 8.5% to the table, which is comprised of 3.9% on Social Security and 4.6% on the ordinary income, which is the dividends, the non-qualified dividends. Point being here is that there are two different buckets that the tax code looks at. One is your capital gains bucket, and the other is your ordinary income bucket. Now, both of those buckets are added together to get to your adjusted gross income, but there are different tax formulas that are applied to ordinary income and capital gains.

When you draw an extra dollar of income from either source, it has the potential to impact the other bucket, not just its own. Okay, for the next layering of income, we’re going to add an IRA distribution. Many of you have heard me for years talk about the tax infestation of your retirement accounts and why we want to address that problem because they are a ticking time bomb. If you stuck with me this far in this video, this is where the payoff really comes. Hopefully, other videos that you’ve watched that we’ve done about tax planning and income planning and everything that we talk about here on YouTube, the Retirement Income Show, for years with thousands of clients, hopefully, this connects the dots.

Adding IRA Distributions into the Scenario

Scenario four, we have qualified dividends, total dividends, qualified dividends. Nothing has changed here from what I’ve previously showed you, except what I’ve added, $25,000 of IRA distributions. We still have the gross social security, we still have the long-term capital gain. Now what we’ve done is we’ve– again, if this is you in this particular situation and you want to go on a trip, but now your son or daughter is asking for some money, you may have the question, “Well, I’m just going to pull it from my IRA. I got a bunch of money in there, no problem. I got this stock that’s not doing well, I don’t want to own that anyway. I’ll just sell that, distribute it, give it to my son or daughter.”

Whatever the life decision facing you have to then turn around and look at all of your sources of assets and say, “Where does it make the most sense to pull it from?” Hypothetically here showing, “Oh, I’m going to go in and I’m going to pull it out of the IRA.” That distribution now is layered on top of all these other sources of income, and it’s not damaging, okay? Our total income gets up to 112, still have the standard deduction, taxable income, 79. To get to taxable, we take the adjusted gross income, subtract the standard deduction, we get to taxable income. Because of the Tax Cuts and Jobs Act, rates and buckets are still large, income tax buckets, and rates are still lower.

It’s still a very favorable tax situation, 42.39. It’s not punitive to just kinda willy-nilly make these decisions, but as you’ll see as we go through this and then tie it all together at the end, it can become punitive. I believe it will become punitive at some point later because you’re not addressing the root cause of the biggest problem you potentially have. 42.39, marginal income tax bracket is 12%, but effectively, you’re only paying 5%. Now, I want to point this out because here we can see where we’re going to be, where we’re going to incur the most amount of taxation if we have to make another decision.

If I was working with a client, and we’re in a review, or you call me up and you say, “Hey, Troy, I need another $20,000, something to come up, should I take it from the IRA or the non-IRA?” I’m going to pull up the tax plan that we have for you. I’m going to very clearly see that if you take it out of the IRA, that $20,000, you’re going to pay 12%, whereas we can still fill up that capital gain bucket, long-term capital gain bucket, take money out, and you’re at 0%. Now, I would go back to that range to see how much we can pull out of that capital gain bucket.

Using the Capital Gains Bucket Efficiently

As a matter of fact, here, I’ll just show you. Come down to the capital gain chart. I see, clearly, we can take out about 17, 18. Okay, we can take $17,000 out from the long-term, or add $17,000 into the long-term capital gain bucket, and you’re still going to be paying zero tax, okay? We may do that. I may tell you to take the other 3,000 from your savings or checking, something like that. Now, if we bring that extra dollar, we’ve overflown the capital gains bucket. Now it’s caused every next dollar, no matter where we take it from, it’s going to be taxed at 15% at the income tax level, so if it’s ordinary income tax or 15% at the capital gains level.

If we take one more dollar from long-term capital gains or from your IRA, at this point, they’re treated equally. Okay, our very last scenario here, before we tie this all together, shows a larger IRA distribution. Same thing, 20,000 in qualified dividends, 25,000 in total. Now we’ve increased the IRA distribution to 75, Social Security is still the same, long-term capital gains, still the same. Now, our total income jumps to 162, as well does our AGI. Taxable income, 129, now our tax has jumped up to $15,000. Taking that extra money from the IRA has now increased the tax to $15,000. From a planning perspective, every next dollar we pull from the IRA is actually being taxed at 27%. This is that torpedo.

Every dollar you take from your IRA moving forward, it’s bringing more capital gains into a state of taxation, more of those dividends into a state of taxation. They’re now being taxed because it’s a consequence of you taking that extra incremental dollar from the retirement account. I know this is confusing, but that’s why I wanted to show the math and the percentages so you can start to understand how every single decision that you make of where you take your income from, it has some consequence.

Ultimately, it impacts either the amount of taxes you currently owe or the amount of taxes you will owe by taking one more dollar out of all those different accounts. One of the questions I get all the time is, “Troy, well, why don’t we just optimize all of our taxes for today so we pay the least amount of tax possible and we’ll worry about everything else down the road?” It’s your money. It’s your choice. As an investment advisor, and more importantly, a retirement planner, it’s my job to point out the challenges that you may have with either the path that you’re currently on and present alternatives for you to consider.

We help do the analysis. We share our experience and expertise with you. Ultimately, it’s your money. You’re making the decisions. We have to juxtapose everything that I just went through and how that impacts your taxes today against the future. You’ll hear me talk about this all the time when I say creating visibility. This is why we have the retirement success plan, step one, allocation planning, step two, income, step three, tax planning, step four, health care, step five, legacy and estate planning. All of these decisions, they work together as part of a larger picture.

The Dynamic Roth Conversion Strategy

When you have visibility into how your decisions today are impacting your future, I believe you can make better choices. Here’s what we have to juxtapose this against. This is more of a dynamic Roth conversion strategy where we’re choosing to pay more tax today because we think it’s going to help over the long term pay a lot less in tax. These two cases are not connected. These are both just hypothetical examples. This one, we’re looking at about $1.7 million in retirement accounts, modest spending levels here of around 60, I believe 60, 65,000 a year.

Again, this is just an example. This is implementing a Roth conversion plan where we’re incrementally and strategically, over a series of years, moving money from that tax-infested retirement account over to the tax-free Roth. This is different for everyone, the amount. It’s a systematic process based on your individual analysis. Here’s the piece of information. Look, if we do nothing apples to apples based comparison to a more dynamic and planned Roth conversion strategy, it’s estimated Roth conversion, we pay about $250,000 of income taxes over the course of retirement versus here, $765,000.

It’s about $500,000 in estimated tax savings by looking at the big picture in retirement as opposed to just the year-to-year. Now, I’m going to layer one more concept onto here. Because President Trump recently got re-elected, it is our belief, and it’s likely, that either the existing tax cuts will be extended or some type of new tax legislation will be put into place. What that means is we most likely will have a longer period of time to consider Roth conversions.

Based on your individual analysis and needs, it may make sense to defer these Roth conversions and focus more on your long-term capital gains and some of the other areas maybe we can attack as far as your tax strategy. The environment has changed, and so the plan changes. Main point being here, everything that I went through with you earlier, when do you take Social Security? Which accounts do you withdraw from, the IRA, the non-qualified? Do you invest in dividend stocks? Do you invest in non-dividend stocks, more oriented for growth?

The Need for Visibility Into Future Tax Impact

All of these choices today that we’re making, they need to be made with respect to visibility into your future. Then with that information and sharing our expertise and experience, or if your advisor can do this, great. That’s how you make decisions in retirement to optimize your overall planning. One last note here is we do get asked often, “Well, Troy, why should I hire you? Why should I hire an investment advisor and pay you 1% of my assets?” or whatever that number is. If your investment advisor is just managing your investments, I think it’s ludicrous to charge that one and a quarter.

This is what I believe in retirement they should be doing for the amount of money that you pay them. This is retirement planning. This is tax planning. When you layer that now on top of the investment planning and income planning and estate planning and health care, what we call the retirement success plan, this is how we differentiate ourselves as investment advisors in the country. Whether you work with us and you’re watching this as a client, if you just simply want a second opinion, or your advisor isn’t doing this, or if you like your advisor and you want to keep working with them, I encourage you, send them this video. Say, “Hey, could you help me out with this planning stuff? Do you do this?”

Then hopefully, they can implement this type of planning into your overall plan. If they need help, want to learn how to do this, of course, we would charge a fee. Have your advisor call us, and for a fee, we would help educate your advisor. I hope you enjoyed this video. We look forward to seeing you on the next one.

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