By now, you’ve undoubtedly heard the news that the Social Security Administration (SSA) will increase benefits by 8.7% in 2023, which exceeds last year’s boost of 5.9%, and will be the largest increase since 1981.  The annual increase to Social Security benefits, called the cost-of-living-adjustment (COLA), is meant to help ease the burden of rising costs in all areas of the economy.  While the COLA can help restore retirees’ purchasing power by boosting retirement income, it also has broader implications, notably for taxes and income (or distribution) strategies.

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 Life Income advisor to review your Social Security strategy, discuss your retirement strategy in this inflationary environment or develop a comprehensive financial plan.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

How much should you save for retirement? There isn’t a one-size-fits-all answer to this question because the amount of money needed to meet income needs in retirement is specific to each individual, and based on their unique life circumstances and spending habits. A financial advisor can help develop a retirement plan that keeps you on track to meet your financial goals. They will also constantly reassess whether your financial plans need adjusting as you move through life and encounter unexpected events that might impact the trajectory of your retirement savings.

But whether you manage your retirement assets on your own or use the services of a financial advisor, you need to understand your current financial situation and how it relates to your financial future in retirement. These questions won’t answer how to invest your retirement assets, but they’re a starting point and foundation for building a solid retirement plan.

Like all things in life, you can’t get to where you want to go without first knowing your starting point. Think of these questions as the starting point on your retirement journey, so you can chart–and eventually navigate–a course to pursue your goal.

These questions won’t answer how to invest your retirement assets, but they help you and your advisor understand your financial landscape before mapping a solid retirement plan.

1. How old are you now, and when do you plan on retiring?

While your current age is important, especially if you’re nearing retirement, it is best to think about your life in terms of stages because every stage has unique circumstances. Ideally, your retirement strategy will evolve as you move through these different life stages: young employee, established professional, and retired or planning to soon. The date you plan on retiring might be unknown. You might have dreams of retiring early and traveling the world. Regardless, your vision for retirement is the starting point for thinking about and defining a retirement strategy. Retirement planning addresses the amount of money you’ll need to save, what investments you should have to provide you the possibility of growth, as well as the income you’ll need to support your lifestyle in retirement.

2. What does your spending look like today, and what do you think it will look like in retirement?

Be honest with yourself about your own and your household’s monthly spending. It is highly recommended that you use one of those programs offered by your bank that shows you where your money goes every month, so you have a clear picture of what you’re spending and what you’re spending it on. This exercise is surprising to many when they see how much they spend, especially on non-essentials.

You’ve worked all your life, and when retirement comes, what does that look like to you? Traveling abroad frequently? Downsizing your primary residence or buying a vacation home? Paying for your grandchildren’s college? Be realistic when forecasting the income needed in retirement, and consider using the services of a financial professional to ensure you don’t forget something that could significantly impact your lifestyle and spending patterns in retirement.

3. How long will you live?

The primary consideration for your age of retirement is how many years you’ll need to fund your retirement.People are living longer than ever before, which means that retirees are planning for more years of retirement than generations prior. According to Thrivent, retirees in 1990 had a life expectancy of 75; today, it’s 79. Today’s retirees will need to plan not only for more retirement savings per annum, but potential health costs, long-term care costs, and inflation.

This is a difficult, and emotional, question to answer. A financial professional can help by estimating your life expectancy using tools that take into account your health and savings, and which project how your savings will respond to unexpected life events over time.

4. Are your investment objectives and risk in line with your expected retirement date?

As you near retirement, your investment goals shift from achieving growth to preserving capital. Time horizon is an important factor when assessing your overall level of risk because the time you have to recover losses before you need to start drawing on your retirement assets for income declines. Stock market downturns are inevitable, but if you need to start withdrawing retirement assets after a major sell-off, you’ll miss out when the market corrects itself. You won’t fully participate in the recovery by having less money invested. This is why time horizon and risk are so crucial to retirement planning: you need to ensure that you have the income needed in retirement regardless of what happens in the market and how long you live, which means adjusting your investments as you age and stop working..

5. What will your taxes be in retirement?

It is essential to understand the different accounts you have and how each is taxed. It is likely that you will have accounts with different tax implications (such as a 401(k), Roth IRA, IRA, and taxable investment accounts) because you’ll be in a better position to minimize taxes by strategically taking income across the different types of accounts. It’s also important to be aware of how retirement withdrawals are taxed. For example, suppose you start taking periodic distributions for income from pre-tax retirement accounts. In that case, those withdrawals will be treated as income and could push you into a higher tax bracket. You might want to withhold taxes when taking distributions, so you don’t get hit with a massive tax bill at the end of the year. Furthermore, accounts funded with pre-tax retirement accounts have required minimum withdrawals once you hit a certain age. If you aren’t taking those distributions, then you could be subject to penalties.

Working with a financial advisor on your tax strategy in retirement can make answering this question easier, because they will help ensure you’re following the latest tax rules, avoiding penalties, and minimizing your tax burden.

6. Are you taking advantage of catch-up contributions?

As you approach retirement, it is important to put aside as much money as possible and take advantage of catch-up contributions. By 50, hopefully, you’re able to start taking advantage of these catch-up contributions to grow your savings more quickly than in previous years because every dollar counts down the road.For the calendar year of 2022, individuals over 50 can now put $27,000 into their 401(k) accounts instead of the $20,500 maximum for those younger than 50. You can also contribute $7,000 to your IRA and Roth IRA this year, an increase from the $6,000 limit in prior years. At 55, you can contribute an additional $1,000 per year to your health savings account.

7. How could inflation impact your retirement savings?

This is an important question to ask any time, but with inflation at record highs, it has never been more important. Rising prices affect your purchasing power parity (PPP), or the buying power of your money. This means your savings won’t go as far as they once would. Even small increases in inflation can impact your retirement savings, especially if inflation rises higher than your investments’ returns. Inflation should be a consideration in your retirement planning. An advisor can help you navigate inflation by utilizing strategies and certain securities designed to potentially mitigate the effects of inflation on your retirement savings.

Conclusion

As Antoine de Saint-Expuery wrote in his famous children’s book The Little Prince, “A goal without a plan is just a wish.” It is never too early (or too late) to save for retirement.The most effective retirement planning evolves as you move through life’s different stages, adapting to your needs and life’s contingencies. A financial professional can help you prepare for your future and eliminate the fear of uncertainty associated with retiring so those years can be some of the best of your life.

If you’re ready to get started, please get in touch with us. We’d love to help create a financial plan for you and your unique retirement scenario.