The end of the year is the perfect time to engage with your financial advisor at Holistic Planning and have meaningful discussions about your financial future. Collaborating with a trusted professional can provide invaluable insights, guidance, and strategies to help you achieve your goals. To make the most of this year and your financial planning journey, here are some key topics to cover with your financial advisor at your year end review:
What does this mean for you?
In this article, we will discuss how the COLA works and what the impact of this upcoming increase in Social Security benefits could mean for your overall financial strategy in retirement.
Social Security is complex and generally a component of a broader retirement strategy that includes income from multiple sources. Since the goal of any retirement strategy is to maximize income while minimizing your tax burden, Social Security benefits should not be viewed in isolation and must be considered within your broader retirement plan.
What is COLA and its relation to Social Security benefits?
The COLA for 2023 is 8.7%, which translates to an average increase of about $140 per month for those receiving Social Security benefits. That equates to more than $1,680 a year, though the actual amount will vary depending on your 2022 benefit. The first payments at this higher level will go out in January 2023.
Congress linked the Social Security COLA to the year-over-year percentage change in the Consumer Price Index (CPI) to ensure that Social Security benefits are not eroded by inflation.
Why has Medicare been discussed alongside COLA?
The standard Medicare Part B premium will fall slightly to $164.90 per month in 2023 from $170.10 in 2022. This is the first premium decrease in about a decade. Medicare Part B premiums are generally deducted from Social Security benefits, so the minimal reduction will mean retirees can benefit marginally more from the benefits bump.
What are the pros and cons of the COLA?
As mentioned above, the increase in Social Security benefits will likely help retirees better meet their living expenses. Whether it is enough will vary by person and depend on their overall spending habits and broader macroeconomic and market dynamics at play. The main thing for retirees to consider is how the COLA could impact their tax situation. While an increased benefit seems positive, it could result in some retirees having more of their Social Security benefits taxed because of how Social Security benefits are taxed.
Social Security benefits are taxed based on a formula known as “combined” or “provisional” income. Taxes on Social Security benefits apply to single taxpayers starting with $25,000 in combined income, and married taxpayers starting with $32,000 in combined income. The combined income thresholds used for determining when Social Security benefits become taxable are not adjusted for inflation, so the COLA could push more Social Security beneficiaries to pay taxes on their benefits.
Additionally, the percentage of Social Security benefits that are taxable is also determined by combined income, which means another impact of the COLA is that it could push more Social Security beneficiaries to be taxed on a larger portion of their benefits, which is discussed in more detail below.
How is Social Security taxed relative to and in conjunction with other income sources?
Social Security benefits are treated as income and taxed according to an income formula that includes earnings (wage income), interest income (percentage yield paid on bank deposits and certificates of deposit, as well as coupon payments on bonds), dividends (income paid by corporations to stockholders of record), pension payments (distributions from a defined benefit plan that have accumulated due to years of service), and taxable distributions from retirement accounts such as traditional 401(k)s and/or IRAs.
As Social Security benefits adjust upward for inflation and additional income is needed for retirement (whether through withdrawals from taxable accounts or even retirees getting part-time jobs), the thresholds for the taxation on Social Security benefits remain constant and don’t adjust upward for inflation. This generally means that, over time, more and more retirees will cross these thresholds and pay more taxes on their Social Security benefits. In 2023, the income tax brackets (which define the taxation thresholds broadly) have also increased, so there is some added benefit and flexibility coming in the same year as the largest COLA in 40 years.
If you file an individual tax return and your combined income is above $34,000, up to 85% of your Social Security benefits may be taxable. If you file a joint return and your combined income is above $44,000, up to 85% of your Social Security benefits are potentially taxable. For individuals with combined income between $25,000 and $34,000, and for couples with combined income of $32,000 to $44,000, up to 50% of Social Security benefits could be subject to tax for both groups. Below these thresholds, a smaller percentage of benefits are taxed.
In simple terms, the more money you withdraw or other sources of income you have in retirement, the higher your combined income will be, resulting in a larger portion of your Social Security benefits being taxed as ordinary income.
How might the COLA impact my tax situation?
Since income tax brackets will also adjust higher to account for inflation, there will be a potential reprieve for retirees worried that the higher benefits could push them into a higher tax bracket. However, the thresholds used for determining the percentage of Social Security benefits that will be taxable are not adjusted for inflation, so the COLA could result in higher taxation of Social Security benefits.
While much focus has been given to the COLA there are other factors at play influencing taxpayers’ combined income, which determines taxation on Social Security benefits, and tax bracket. With inflation running high, many retirees might also need to withdraw funds from retirement accounts, thereby increasing their combined income, which is the measure used to determine the taxation on Social Security benefits. Additionally, higher interest rates in the last year by the Fed could result in higher interest income for retirees that parked cash in savings accounts offering higher yields, CDs, or even I Bonds. The higher your income, the larger the percentage of your Social Security benefits will be taxed as ordinary income.
While all of this can be concerning, a strategic financial plan can help you maximize your retirement income while minimizing your taxes. Furthermore, by being flexible in your retirement strategy and proactive about tax planning, there are ways to manage the potential tax consequences of the COLA increase, the current inflationary environment, and other factors.
What strategies could help manage the potential tax implications?
It is essential to review your spending habits in retirement at least annually to optimize the amount and source of any withdrawals. While the COLA increase might be enough to help some retirees with their day-to-day living costs, others might still need to increase distributions for additional income to fund their spending, given surging prices and other factors, such as stock market declines and a softening housing market. Effectively implementing tax strategies can be complicated, so working with a wealth advisor or tax professional can be beneficial. The following strategies are not meant to be advice, and we recommend implementing them based on your circumstances and in consultation with a professional.
- If you are in early retirement, a Roth conversion can be a smart way to take advantage of lower tax rates. While you’ll be taxed on the amount you convert, once the assets are invested in the Roth, they’ll grow tax-free, and any future withdrawals won’t be subject to taxes.
- If you need additional income, consider qualified withdrawals from a Roth IRA, a Roth 401(k), or a health savings account (HSA), since these would not be subject to federal income tax and wouldn’t impact how your Social Security benefits are taxed. It is important to consider that Roth IRA earnings distributions are subject to a 5-year rule in order to be tax-free, and HSA withdrawals are only tax-free when used to pay for qualified health expenses. Also, don’t forget that assets in these accounts grow tax-free, so there is a benefit to keeping them invested and avoiding withdrawals except when necessary.
- If you need to withdraw money to cover spending, consider liquidating securities in brokerage accounts that have been held for over a year since you’ll most likely be subject to long-term capital gains tax treatment on the investments sold. which are generally lower than short-term capital gains tax treatment, Gains on securities sold that have been held for a year or less are subject to short-term capital gains, and they generally are taxed as ordinary income.
- Minimize withdrawals from retirement accounts (except for required minimum distributions) such as traditional 401(k)s or IRAs as these will be taxed as ordinary income and impact your tax bracket, as well as the taxation rate on your Social Security benefits.
How should I think about my overall financial plan in light of recent inflation and the upcoming COLA?
While cost-of-living adjustments are often seen as a benefit in inflationary environments, you should incorporate them into a strategic approach that can help maximize your retirement income while minimizing your taxes. A goals-based financial plan can help you navigate this period of high inflation and the associated tax implications; however, we believe in long-term and holistic planning that addresses today’s needs within the context of your broader financial plan and over a longer time horizon. While solving for income needs and tax implications in any one year or over short periods is sometimes needed, especially during inflationary environments, we encourage clients not to lose sight of their longer-term and strategic financial plan.
Please schedule a complimentary consultation if you’d like to meet with a financial advisor to discuss our comprehensive and holistic approach to retirement planning that takes all of these questions and considerations into account.