Before the Social Security Act of 1935 became law, seniors didn’t have any sort of financial safety net beyond pensions that were being paid to disabled veterans of the Civil War or their families. Today, Social Security provides a critical source of money to more than 43 million retired workers, many of whom count on it for more than half their annual income. Since Social Security is key to achieving financial freedom in retirement for most, it’s important to make sure you don’t lose out on benefits because of Social Security’s earnings limits and federal tax rules.
Here’s how you can use a Roth IRA as part of a retirement planning strategy if you claim Social Security early.
Sidestepping Social Security’s earnings limit
A Roth IRA allows you to contribute after-tax money now that can be withdrawn tax free in retirement. In addition to the benefit of tax-free growth, withdrawing money from a Roth IRA can also help workers who claim their Social Security benefits early avoid withholding because of Social Security’s earnings test.
As a refresher, workers can contribute up to a specific limit of their earnings in after-tax dollars to a Roth IRA every year. In 2019, that contribution limit is $6,000 if you’re under age 50, or $7,000 if you’re age 50 and up due to catch-up contribution rules.
Since Roth IRA contributions are made with after-tax money, those contributions can be withdrawn tax free at any time. Also, if the Roth IRA is open at least five years and you’re age 59.5 years or older, then earnings on contributions can be withdrawn tax free too.
This means that if you claim Social Security early, you can use tax-free withdrawals from a Roth IRA to supplement your income, thereby reducing the risk of failing Social Security’s earnings test if you continue working.
You can begin drawing your Social Security benefits as early as age 62, but Social Security only pays you your full benefit amount if you wait until your full retirement age to claim, which varies between age 66 and age 67 for people born after 1954. Despite the reduced benefit, age 62 remains the most common age for people to claim their benefits, and many who claim prior to attaining their full retirement age do so while continuing to work part time.
Working while receiving Social Security benefits early is OK, but it exposes you to Social Security’s earnings test, and failing that test can result in a good chunk of your benefits being withheld.
In the years prior to the year you turn full retirement age, $1 will be withheld for every $2 earned above an annual limit ($17,640 in 2019), and $1 will be withheld for every $3 earned above a limit in the year you reach full retirement age ($46,920 in 2019).
A Roth IRA can help you avoid triggering withholding caused by failing the earnings test by providing you with tax-free earnings you can use to bridge the gap between the earnings limit and your expenses.
For example, let’s say you’re age 62, collecting $700 per month in Social Security, and your monthly expenses are $2,500. The earnings test limit in 2019 allows you to earn up to $17,640, or $1,470 per month, without triggering a reduction, so $1,470 plus $700 equals $2,175, which is $325 per month shy of your obligations. If you work more to cover those remaining expenses, you’ll fail the earnings test. But if you withdraw the $325 per month you need from a Roth IRA tax free, you’ll avoid triggering the withholding, allowing you to pocket the benefits you’re entitled to.
It can reduce your tax bill too
Tax-free withdrawals from a Roth IRA can also reduce the likelihood that your Social Security will be subject to federal income taxes.
If you’re single or married filing jointly, up to 50% of your Social Security will be taxed if your earnings exceed $25,000 and $32,000, respectively, and up to 85% of your Social Security will be taxed if your earnings eclipse $34,000 and $44,000, respectively. If you don’t plan ahead and you earn too much money from working, then you could pay more in income taxes on Social Security than you need to.
By taking tax-free withdrawals from a Roth IRA to cover expenses above the IRS earnings limits rather than working to earn more money, you can avoid or reduce federal income taxes on your Social Security benefit.
Overall, Roth IRA withdrawals in retirement help you avoid withholding due to the earnings test and federal income taxes, so funding a Roth IRA at least five years prior to claiming Social Security to take advantage of tax-free withdrawals of both contributions and earnings could be smart.
