Page 24 - Investment Advisor March 2022

Cover Story

How to Avoid the

Social Security

Tax Torpedo

Starting early with an aggressive Roth IRA strategy can

help even wealthy clients minimize the tax damage,
Wade Pfau told Investment Advisor.

BY JANE WOLLMAN RUSOFF

atch out for the Social Security Tax Torpedo. Upfront planning is essential to employ his strategy, which
It’s a hugely unwelcome part of 1983 tax needs to begin before the start of Social Security. That time
Wreform, which arrived when the Social frame will be used to draw income from Roth accounts at a
Security Administration trust fund was running out of money. higher tax rate.
But there’s an effective tax-planning strategy to steer clients “Subsequent Roth distributions do not count when deter-
out of the Torpedo’s path. mining how much of Social Security is taxable,” writes, Pfau,
Wade Pfau, professor of retirement income and director of who is co-editor of the Journal of Personal Finance.
the Retirement Income Certified Professional program at The Here are highlights from our conversation:
American College of Financial Services, explores it in an inter-
view with investment Advisor. Investment Advisor: What’s the Social Security Tax Torpedo?
Because the threshold for paying taxes on Social Security Wade Pfau: It’s super-complicated and a kind of trap.
benefits hasn’t been adjusted for inflation since about 1994, Once your taxable income — including Social Security, IRA dis-
more and more taxpayers are — and will be — hit by the Tax tributions, dividends, long-term gains from brokerage accounts,
Torpedo, Pfau says. However, with an “aggressive” Roth IRA part-time or full-time work [etc.] — that is, any measure of
strategy, even folks with “a couple of million dollars in assets income that goes on your Form 1040, is above approximately
can avoid a big chunk of the Torpedo,” he argues. $70,000, you can’t avoid the Tax Torpedo [kicking in]: You’re
The goal is to have less taxable income later in life when going to be paying taxes on 85% of your Social Security benefits.
receiving Social Security since once a worker begins collecting
and their taxable income — from all sources — is above approx- What’s a concrete example?
imately $70,000, they must pay taxes on 85% of their benefits. Suppose you’re in the 22% tax bracket. If there’s a point where
People who have “relatively modest resources” should use one dollar of income causes 85 cents of a dollar of your Social
the Roth conversation strategy, but “wealthier individuals may Security benefits to become taxable, then suddenly you’re not
find that avoiding the Tax Torpedo impossible,” he writes in in the 22% tax rate any more — you’re paying more than 40%
his Retirement Planning Guidebook, Navigating the Important as a tax rate.
Decisions for Retirement Success, which came out in late 2021. And if that also pushes a dollar of your long-term capital
Pfau recommends that financial advisors start talking about gains from the zero percent tax bracket to the 15% tax bracket,
the Tax Torpedo early in clients’ retirement planning process. now [that] tax rate [goes up too].

22 INVESTMENT ADVISOR MARCH 2022 | ThinkAdvisor.com