Planning strategies should be done based on marginal tax rates, which means the leaps in marginal tax rates from including Social Security benefits can and should be a material factor in planning - especially since the rates have the greatest impact on those whose income is relatively modest and may not realize they are exposed to 27.75% (or even 46.25%!) marginal tax rates when they "thought" they were in just the 15% or 25% tax brackets.
Strategy 1. Accelerate Income and Lump It Together
For many people and in many situations, there simply is not enough income flexibility to spread income out to stay below the thresholds. For some people, the best action is to actually accelerate income and lump it together; after all, additional income beyond the point that the maximum 85% of Social Security benefits are taxable is subject to only a 15% (or 25%) tax bracket, which is far better than leaving the income until next year when it may be taxed at 27.75% (or 46.25%) due to the phase-in of Social Security benefits. In fact, in some cases it might even be worthwhile to trigger a bit of additional Social Security benefits taxation just to reach the cap and then add more income beyond it at a current tax bracket!
Strategy 2. Manage Income Earlier
In other situations, the best thing to do may be managing income earlier to avoid exposure in the later years. For instance, Roth conversions before someone starts Social Security benefits can leave a more flexible pool of money to draw upon in the later years - not to mention avoiding RMDs - allowing the person to avoid 22.5%, 27.75%, or 46.25% marginal tax rates down the road. Of course, the caveat for Roth conversions is still not to do too much at once, driving up the current tax rate to an untenable level, as the primary benefit of Roth conversions is still to do them when current rates are lower than future rates!
Nonetheless, if the reality is that future tax rates will be 22.5%, 27.75%, or greater, then doing partial Roth conversions to fill the lower tax brackets now to avoid those higher marginal rates in the future is certainly a good deal. And alternatively, some people who currently face these rates might still do partial Roth conversions getting through the taxability of Social Security benefits, so they can do additional Roth conversions that year above the Social Security taxability cap at favorable tax rates to further reduce exposure down the road.
There are two more strategies one could consider, we will discuss in our next blog post and wrap up the entire series.