The largest Social Security cost-of-living adjustment since 1981, 8.7%, has good news written all over it. But an irritating sidebar accompanies that: higher taxes on Social Security benefits.
"There are some quirks in the tax code that can result in very high marginal tax rates in certain situations," Christopher Jones, chief investment officer and executive vice president of investment management at Edelman Financial Engines, tells ThinkAdvisor in an interview. "So if you get a few more dollars of income and it pushes you into the 85% bracket, that can be pretty onerous."
Jones recommends that retirees with sources that augment their Social Security benefits, such as investment accounts, "determine the best way to take money out of these to minimize their taxes."
Back to good news about the big COLA: Medicare premiums will drop a bit in 2023. That means "the COLA won't be offset" by the premium that's deducted from folks' Social Security benefits every month, Jones says.
Meantime, the 2022 bear market has caused workers' 401(k) accounts to be hit substantially. The median balance for "the 60 to 65 age cohort is probably [about] $75,000 to $85,000," says Jones, while the average balance for a 65-year-old is "probably 15%-20% lower this year" compared to the approximate $250,000 the data suggested prior to 2022, according to Jones.
And that average balance is "heavily impacted by some pretty large 401(k) balances out there," he notes.
Jones, author of "The Intelligent Portfolio: Practical Wisdom on Personal Investing from Financial Engines" (2017), was the third employee hired at the legacy Financial Engines, founded by Nobel laureate William F. Sharpe in 1996.
Before the 2018 merger of Financial Engines and Edelman Financial Services, Jones held the post of executive vice president and chief investment officer at Financial Engines.
ThinkAdvisor held a recent phone interview with Jones, who was speaking from his base in Santa Clara, California.
Amid the long-running debate about the Social Security system of the future, he forecasts "adjustments in the way benefits are paid and the way the system is funded, probably in the form of higher taxes."
Here are highlights of our conversation:
THINKADVISOR: Will the 2023 large cost-of-living adjustment (COLA) increase result in Social Security recipients paying higher taxes on their benefits?
CHRISTOPHER JONES: Yes, that's an unfortunate side effect of a big COLA, which this year is [8.7%]. That's the biggest one we've had in a long time.
The marginal tax brackets that apply to Social Security income aren't indexed to inflation. That means a higher proportion of those benefits, which are going up in nominal terms, are likely to be taxed. That's usually at either 50% or 85%, depending on income level.
Those who augment their [Social Security] income with a pension or other annuity sources or from investments need to determine the best way to take money out of these investments to minimize their taxes.
That's important for retirees. It can make a significant difference in the amount of after-tax money they get to consume.
The tax code is pretty obtuse for most folks, so figuring out how to optimize decision-making requires consulting with someone who has expertise in this area.
Can this large COLA push someone into a significantly higher tax bracket?
There are some quirks in the tax code that can result in very high marginal tax rates in certain situations.
So if you get a few more dollars of income and it pushes you into the 85% bracket, that can be pretty onerous.
But the COLA is still beneficial. It's much better for folks who are living on Social Security to get the additional income to cover the impact of inflation than to not have it, though it can mean your tax bill will be a little higher next year.
The Medicare premium for health insurance coverage is set to drop in 2023. That appears to be good news. Is it?
Yes. It means the COLA won't be offset by the Medicare premium.
But as great as it might seem, the reason it's dropping is that last year the premium went up a lot because of a new Alzheimer's drug that was approved.
Now they're realizing that fewer people are taking advantage of getting it or are unlikely to get it. That's why the premium is going to drop a bit this year.
Which provides more income for retirees: the average 401(k) account or Social Security?
Obviously, 401(k) accounts are down in 2022 because almost every asset class is down.
But the most relevant data I've seen from the big record keepers suggests that for a 65-year-old, the average 401(k) balance was on the order of about $250,000.
It's probably 15% or 20% lower this year. That's the average, and it's heavily impacted by some pretty large 401(k) balances out there. Some people are able to accumulate $1 million or more.
What do you think the median 401(k) balance is, then?
For the 60 to 65 age cohort, it's probably under $100,000 — something like $75,000 or $85,000. That's a fairly modest number to provide for somebody over a lifetime.
About a third or so of people in that age cohort have both Social Security and pension income. So depending on their level of income, that will cover most of their needs.
But the trend has been to fewer pensions available to workers, right?
Every few years we're seeing a cohort of retirees who have less and less access to pension income and who are more and more reliant on their 401(k) to fund their retirement.
