Social Security COLA Could Have Surprising Tax Effects

Since only 50% of Social Security income is counted as provisional income, you might think that only 50% of the COLA would count against the client in determining taxable benefits. When you pair that with a roughly 7% increase in tax brackets for 2023, you may be considering increasing IRA withdrawals by 7% to try to keep up with inflation, but the math doesn't work. 

In spite of the fact that tax brackets are increased by inflation (though a different measure than Social Security benefits), the thresholds for determining taxable Social Security benefits are not increased, which produces some unusual results.

For example, a married couple with a $35,000 Social Security benefit in 2022 who withdrew the maximum from their IRA without paying any federal tax and is trying to follow the same strategy for 2023 could increase their IRA withdrawal by about 3.4% and get the same result. A couple with $80,000 of combined Social Security benefits would have to reduce their IRA withdrawal by 3.7% to achieve the same result. Clearly there is no rule of thumb here.    

The key is evaluating every client's tax situation yearly to target the blend of withdrawals from various sources to keep the client's marginal tax rate at a level that fits their long-term financial strategy. Some financial planning software can do these calculations for you to make this process faster and easier. 

Social Security benefits are a unique weapon in a financial advisor's arsenal because they are directly and immediately tied to inflation. Common wisdom holds that equity ownership is essential to outpacing inflation over time. Still, in periods of rising inflation, as we're seeing now, stocks don't move immediately with inflation and may even go backward. Bonds are no haven either since rising interest rates frequently mark inflationary periods. 

Advisors who optimize Social Security as part of their planning strategy frequently recommend a higher concentration of Social Security income through the later years of retirement, providing a more robust inflation-adjusted and longevity protected income floor for their clients. The ability to explain and demonstrate the impact of inflation on Social Security benefits and the client's withdrawal strategy to produce after-tax income can help you create and retain clients for life.

Joe Elsasser is the founder and president of Covisum, a financial technology company focused on creating software that improves lives through better financial decisions. Covisum helps financial advisors serving mass-affluent clients in or near retirement and powers some of the nation's largest financial planning institutions.