Inflation has been hitting everyone’s wallets all year long. With the cost of everything from fuel to pasta going up, a 40-year high in the cost-of-living-adjustment (COLA) for social security sounds like a good thing. But is that all there is to it?
The answer is complicated. For those already retired or considering retiring in 2023, it's not as simple as getting an extra approximately $140 per month. The retiree's "paycheck” usually depends on income from several sources: social security, pensions, tax-deferred retirement accounts such as 401(k)s and IRAs, taxable accounts and interest-bearing savings accounts, and other interest-bearing investments.
It's critical to ensure your retirement income is subject to the least amount of taxes possible. Since up to 85% of social security benefits are taxable, it's essential to look at your entire financial picture from a tax perspective.
While social security has increased, the Federal Reserve's attempts to curb inflation have focused on raising interest rates, and more increases are in store. Short-term rates are likely to hit more than 4% by the end of 2022, after years of essentially zero-percent interest on cash. This can increase your taxes because interest income is taxable at the ordinary income tax rate. Many retirees hold enough in cash to fund several years of living expenses – so it’s worthwhile to do the math and figure out how this may change your tax picture
What’s Happening With Social Security Benefits?
The COLA for 2023 is 8.7%, which translates to an average increase of about $140 per month. All but 15% of social security benefits are taxable, and the percentage subject to taxes depends on your income.
If you file an individual tax return and have combined income between $25,000 and $34,000, you may have to pay tax on up to 50% of your benefits. If you exceed $34,000, up to 85% of your benefits may be taxable.
If you file a joint return, combined income between $32,000 and $44,000 may result in up to 50% of benefits being taxed. Over $44,000 exposes you to a potential tax of 85% of your benefits.
What Happens if You Work While In Retirement?
The monthly benefit for existing retirees is just one of the impacts of the COLA. Other parts of social security are adjusted as well.
With full retirement age (FRA) nearing 67 for many retirees, it's becoming increasingly common to retire from full-time work before you reach FRA. But many retirees take on part-time work for a variety of reasons, including personal fulfillment, a desire to stay busy, and a need to supplement income. The problem is that until you reach full retirement age, social security reduces your benefit if your income exceeds certain limits.
If you are under FRA for the entire year of 2023, $1 in benefits will be withheld for every $2 in earnings that exceed $21,240. If you reach FRA in 2023, $1 in benefits will be withheld for every $3 in what you earn over $56,520 prior to reaching FRA.
Once you reach FRA, there is no impact on your benefits, no matter how much you earn.
The Sources of Your income Are Important
The income tax brackets have also increased – so there is a little more flexibility. The new brackets are as follows:
- 10%: $1-11,000 for singles and $0-$22,000 for couples
- 12%: $11,001-$44,725 for singles and $22,001-$89,450 for couples
- 22%: $44,726-$95,375 for singles and $89,451-$190,750 for couples
- 24%: $95,376- $182,100 for singles and at $190,751-$364,200 for couples
- 32%: $182,101-$231,250 for singles, and $364,201- $462,500 for couples
This is where the tax puzzle comes into play. The key is to be proactive about tax planning. If you are in early retirement, you may consider a Roth conversion to fill up lower tax brackets. You’ll be taxed on the amounts you convert, but once invested in the Roth, the funds will grow tax-free, and you won't be taxed on future withdrawals.
But you'll need to be thoughtful and consider your entire picture. Increases in social security, combined with increases in taxable interest income (remember those I Bonds that are paying close to 10%?), along with withdrawals from tax-deferred retirement accounts, can push ordinary income higher.
It may be enough to bump you into a higher level of taxation on social security.
If you're getting insurance under the Affordable Care Act with a subsidy, you'll want to be careful that income doesn't get to a level that decreases or eliminates your subsidy amount.
Cost-of-living increases in social security are permanent and can be seen as one upside of the inflationary environment we've been in for the last couple of years. But for retirees, it's important to consider each piece of your income and taxation and to understand the moves you can make to keep more money in your pocket.
At Envision Financial Planning we can work with you to navigate the complexities of your financial situation and help you lower your tax liability at year-end. We all love surprises but not a tax surprise when you least expect it. Planning happens year-round so you’ll know exactly when you stand when it comes time to file your tax return.