An Orion study recently found 80% of investors believe their advisors should focus on minimizing their tax obligations, especially for clients in retirement, said Joe Elsasser, Covisum founder and president, during a recent webinar that focused on retirement tax strategies for RIAs.
With that in mind, he began by reviewing Social Security taxation, which he said should be a first step for advisors. He also discussed capital gains taxes and Roth conversions, among other areas where taxes can get tricky.
Provisional Income
Provisional income is a measure used by the IRS to determine when Social Security benefits are subject to income tax. It is calculated using:
- Half of Social Security benefits.
- Ordinary income, including any IRA withdrawals or wages
- Dividends and capital gains
- Nontaxable Interest
For a married couple, Social Security benefits are not taxed until provisional income reaches $32,000. On provisional income between $32,000 and $44,000, half of Social Security benefits are taxed. Above $44,000, 85% of benefits are taxed.
For individuals, half of Social Security benefits are taxed when provisional income is between $25,000 and $34,000. Above that threshold, 85% of benefits are taxed.
The sources from which provisional income is drawn can make a huge difference on taxation, Elsasser pointed out. For example:
1) In a year, a couple receives $40,000 in Social Security benefits and takes a $20,000 IRA withdrawal. That is $40,000 of provisional income ($20,000 in Social Security and $20,000 from the IRA). The $40,000 minus that $32,000 threshold equals $8,000, of which 50% is taxed. The couple will pay income tax on $4,000, or on 10% of their income.
2) In a year, another couple receives $20,000 from Social Security and withdraws $40,000 from their IRA. This is $50,000 of provisional income ($10,000 from Social Security and $40,000 from the IRA), which when subtracted from $32,000 comes to $18,000, of which $9,000 is taxed. Meanwhile, $6,000 of their income will be above the $44,000 threshold. An additional 35% of that income, or $2,100, will be taxed. This means the total taxable benefit is $11,100 ($9,000 plus $2,100), or on 22% of their income.
Further, when the standard deduction is taken into account, the second couple reaches a net taxable income of $22,400. Couple number one comes up with taxable income of zero. Since their taxable income is below the standard deduction, the first couple could even take out a little more from their IRA and still pay no income tax, Elsasser pointed out.
Capital Gains Tax
Elsasser also emphasized that ordinary income can increase a retiree's capital gains tax rate. In 2021, the 0% bracket for the capital gains tax was $83,350. Add the standard deduction, and a couple could earn up to $112,050, in capital gains and ordinary income combined, before being liable for any capital gains tax.
But, Elsasser said, let's say a client had $100,000 in capital gains with $28,000 of ordinary income. The ordinary income is "stacked" under the capital gains, pushing the gains above the $112,050 threshold into the 15% tax bracket.
"There is an interaction we really want to pay attention to because it matters a lot when we're working with clients on these tax plan strategies," he said.
