income tax, calculator, accounting

How to Plan for a Client’s Provisional Income in Retirement

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Provisional Income may not mean much to you unless you are currently receiving Social Security benefits. However, one of the most engaging topics that we cover in our Social Security education class is the impact of taxes on benefits. Many adult learners who attend don’t know that their Social Security benefits will likely be subject to tax. Of those few who do, many are unaware how it is determined, how much they are likely to pay, and what if anything can be done about it. 

Wouldn’t it make sense to limit your exposure to unnecessary taxes in retirement if at all possible? After all, any income that goes towards paying taxes reduces what you can spend to maintain your lifestyle throughout retirement. Would it be nice if we could create a plan that maximizes the retirement resources you have in retirement and minimizes your tax burden.

Provisional Income

Understanding how provisional income is calculated is the key to understanding what percentage of your Social Security benefits will be subject to tax and what, if anything, can be done to reduce the impact of taxes on your benefits. There are four main components in the provisional income calculation.

They include:

  1. 50% of Social Security benefits
  2. Ordinary Income 
  3. Other Taxable Income
  4. Tax-Free Income

Let’s explore how each of these individual components impacts the taxes on your Social Security benefits.

50% of Social Security Benefits

We begin calculating provisional income by determining the Social Security benefits that your household will receive for the calendar year. Then we divide that benefit by 50%. For a husband and wife filing jointly, we’d combine both Social Security benefits and then divide by two. For example, if a husband and wife are each receiving a monthly Social Security benefit of $1,000 per individual per month, their household is receiving $24,000 of Social Security benefits annually. Half of their household Social Security benefits ($12,000) would be included in calculating their provisional income.

Ordinary Income

Next, we total all other taxable income. We’ll start with ordinary income. What’s ordinary income? Are you employed and earning a paycheck? You are earning ordinary income. What if you are retired and no longer earning a paycheck? You still might be receiving ordinary income.

Distributions from retirement assets such as 401(k)s and IRAs are considered ordinary income. Think of your 401(k) or IRA as an I.O.U. to the IRS. Why? Because the money contributed to these plans — along with any growth — has never been taxed. You chose to defer all taxes until they distributed.  Additionally, if you’re fortunate enough to have lifetime income from a pension, it is generally received in the form of ordinary income.

Considering the proliferation of defined contribution plans like 401(k)s and personal savings in traditional IRAs over the past three decades it is likely that a significant portion of your retirement income will be received as ordinary income. It is foreseeable that your household’s provisional income might soar rapidly as you distribute more and more assets in order to maintain your inflation-adjusted lifestyle throughout retirement.

Other Taxable Income

Do you own after-tax savings and investments? There’s a good chance you’ll also receive realized interest and capital gains, as well as dividends from those investments. Interest from checking, savings, and money market accounts as well as certificates of deposit are considered taxable income. Realized capital gains on investments that have been sold are also included, along with dividends earned from dividend-producing investments. All of this additional taxable income affects your household’s provisional income.

Tax-Free Income

Municipal bonds are popular investments for retirees who desire tax-free retirement income. Interest earned from municipal bonds is generally federal income tax free, and potentially state income tax free, if the municipal bonds are purchased within your resident state. However, the interest income earned from municipal bonds is included in provisional income. Surprised? The tax-free investment income from municipal bonds may contribute to the taxation of your Social Security benefits.

Thresholds

For decades cost of living has increased, but thresholds determining whether you pay taxes on your benefits haven’t. For a single filer, the first threshold is only $25,000 of provisional income. For a married couple filing jointly, the first threshold is only $32,000. Once this threshold is surpassed, a portion of your social security benefits will become taxable at the highest marginal tax bracket of the household.

For many retirees, staying below this threshold will be an increasingly difficult challenge. For some, maintaining their lifestyle and staying below the threshold will be nearly impossible. However, managing your provisional income may protect some of your Social Security benefits from being taxed at the next highest marginal tax bracket.

Non-Provisional Income

You may be wondering, are there any retirement income sources that are not included in provisional income? This is a question many of our adult learns want to know. The answer is yes! Under current tax law there are a couple of sources that are not included in provisional income. 

Roth IRAs

Distributions from Roth IRAs are not included in provisional income. Therefore, one strategy for reducing provisional income for pre-retirees who are planning far enough in advance is to leverage Roth conversions. This strategy allows them to pay off their I.O.U. to the IRS in a controlled manner and on their terms. Many choose to convert those assets from forever-taxed to never-taxed prior to electing Social Security benefits. Controlling when and how you pay taxes on your retirement assets is one strategy to reduce your provisional income in retirement.

Cash Value Life Insurance Distributions

Distributions from cash value life insurance may also avoid inclusion in provisional income. Under section 7702 of the Internal Revenue Code (IRC) distributions from a properly structured cash value life insurance policy are free from federal income tax, and would not be included in calculating provisional income.

Advanced planning is necessary in order for a comprehensive retirement income plan to take advantage of either or both of these strategies. Pre-retirees should begin planning when and how their taxable retirement assets will be distributed at least 5 to 10 years before their desired retirement date. Unfortunately many workers put off planning for their retirement income, making it nearly impossible to enjoy significant benefits from implementing these strategies.

Creating the Most Efficient Plan for Clients

Retirement income planning is a complex dance between retirement resources including income and assets, inflation-adjusted expenses, various rates of return, taxes, and entitlement benefits such as Social Security and Medicare. Provisional income is one of many considerations in order to optimize a retirement income plan.

While it may become increasingly more difficult to pay no taxes on Social Security benefits due to a low threshold, proper planning may significantly reduce the percentage of your Social Security benefits that are subject to tax, and the highest margin tax rate that will be applied.

In the end, it’s all about putting more spendable income into your household and losing less to taxes as a result of incomplete planning. Our clients are real people who need real income to buy real things in retirement. Strategies that will minimize the impact of taxes, fees, and marketable investment losses, often result in more money for them to spend so they can enjoy and maintain their lifestyles throughout retirement.

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