MY WIFE VICKY AND I have lately been discussing—yet again—when to claim our Social Security retirement benefits. We’re fortunate to have multiple sources of retirement income, including a defined benefit pension, traditional IRAs, Roth IRAs and two health savings accounts.
To date, we had assumed we’d both delay claiming Social Security until age 70, so we get the largest benefits possible. Until then, we’d planned to live on my pension, any consulting income I earn, and withdrawals from our retirement accounts. But we’re now rethinking that plan for a handful of reasons:
Collecting some Social Security income right away is also appealing from a tax point of view. As I mentioned above, Social Security income has tax advantages at the federal and state level compared to other retirement income.
I’m especially focused on New Jersey’s retirement-income exclusion provision, which includes three “cliffs”—for joint filers they’re at incomes of $100,001, $125,001 and $150,001—that can trigger a big jump in state taxes. If we claim Vicky’s benefit now, it would reduce how much other retirement income we need and potentially help us avoid stumbling over these tax cliffs.
After considering all the variables, we’ve decided to start Vicky’s Social Security benefit in 2023. She can apply for Medicare next month, at which time she’ll submit a joint application for both Medicare and Social Security. The latter will give us some inflation protection, thanks to Social Security’s annual cost-of-living adjustment, which next year will be 8.7%.
Even with Vicky’s Social Security, my pension and other income, we’ll still have a shortfall between the income we receive and what we spend. To fill this gap, I’m looking at several options. I could continue to do monthly withdrawals from our cash fund. This money is held in Vanguard’s Short-Term Bond ETF (symbol: BSV). The fund has a current yield of around 4.8% and a low expense ratio of 0.04%. Unfortunately, the fund hasn’t been immune to this year’s market woes, falling 6% year-to-date.
Another option I’ve been considering is a period certain immediate annuity. This type of annuity provides immediate income for a specified period of time. This is one way to bridge the five years between now and when I claim my Social Security at age 70. One of the benefits of a period certain annuity is you’re guaranteed to receive all the payments. Should I die within the five-year period, my wife—or her heirs—would receive the remainder of the 60 payments.
I looked at five-year annuity pricing through Fidelity Investments and ImmediateAnnuities.com. The two sites provided essentially the same result. A 65-year-old male, living in New Jersey, would get some $3,500 a month for a $190,000 investment, for a total $210,740 over the five years.
If we choose to go this route, we would fund the annuity from a traditional IRA. The income would thus be federally taxable. It would, however, be eligible for New Jersey’s retirement-income exclusion—provided we don’t end up with too much income and go over the tax cliff.
The wild card in all this is my consulting income. I intend to continue to entertain opportunities. The downside: Any significant earned income could potentially push our state income over New Jersey’s tax cliff.
Another option we have: Tap our health savings accounts (HSAs) and our Roth IRAs. Any income we generate from these accounts won’t boost our taxable income. We plan to use our HSAs to pay our Medicare premiums. The upshot: We’ve decided that our 2023 income plan will look like this:
My analysis shows this plan should cover our core and discretionary expenses, and give us a chance to minimize our tax bill. If my consulting opportunities turn out to be more lucrative than I expect, or we win the lottery, our tax bill will be what it’ll be—and we’ll view it as a nice problem to have.
There’s an old saying in finance: “Don’t let the tax tail wag the investment dog.” This is usually interpreted as, “Don’t make an investment solely based on tax considerations.” I worry a little that I’m violating this tenet with our retirement income plan.
I believe that taxes are part of our civic duty and the price we pay for being financially successful. Still, I plan to track our income throughout the year, and I may make mid-year adjustments to try to minimize our tax bill.
Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. He enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. Follow Rick on Twitter @RConnor609 and check out his earlier articles.
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Your article really brought out the interest from all of us retired engineers it seems! LOL I retired at 50(long story) and been playing this game for awhile now. A mistake early on was just anyalyzing the next few years only. Do your best to take a longer view as the tax man will throw you a curve now and then. I don’t know if you will be impacted, but IRMAA is another cliff to watch out for and grows over time if ones RMDs grow faster than inflation which is common. Another one is taxability of SS as you mentioned – this is a bit more complex than first meets the eye as some will have the percentage taxable increase with increasing RMDs(or other income). Watch out for, as it also impacts the IRMAA cliff(and it sounds like a NJ cliff for you).
When not impacted by a significant cliff I have chosen to spend down my post tax savings to reduce future income and do Roth conversions(being mindful of cliffs) to reduce the cliffs in the future which could be large.
Also on SS even when income maxes out its taxability at 85%, a larger future precentage from SS vs other income is a “win”. By spending from taxable pool now and taking from SS later you move more income to non taxable in teh long run.
Also, as Congress is also impacting you, you cannot be perfect. I turn 72 in 2023 and watching for Secure Act 2.0 to perhaps get one more year of Roth conversions if start age increases from 72 to 73.
Yeah, us engineers like to analyze!!
Hi Rick, thank you for sharing your thought process and the analysis to get to your decision. I enjoy your article a lot, as a fellow engineer by training.
thanks Richard and commenters, I had not heard of the 5-year annuities before. My hope is to retire at 65 in a couple of years and the 5 year annuity could be a good way to bridge until claiming SS.
For those suggesting T-bills or CDs within the IRA – that’s all fun and games until the interest rates drop again. The annuity seems to me a kind of hedge against uncertainty, and I am willing to pay a little for that.
Theoretically you could buy a CD or treasury for 5 years as well. (Or ladder up to 5 years.) Presumably that would provide as much of an uncertainty hedge, and likely more given that they are fully backed by the US government, unlike a company providing an annuity. (Sort of like how a corporate bond is always riskier than a government bond.)
You note in your commentary that you plan to use your accumulated H S A funds to pay for Medicare premiums. I am currently doing so from my H S A as current tax law allows for reimbursement of premiums of Medicare part A (if any), part B and part D but not for Medigap premiums from an H S A account.
There may be a future tax law change as a 2022 bill in the the House would eliminate Part A, B & D Medicare premiums as an eligible medical expense for H S A purposes. Please see https://www.cnbc.com/2022/05/19/you-cant-save-in-hsa-on-medicare-a-bill-to-change-that-has-tradeoffs.html
By reimbursing the eligible Medicare insurance premiums from your H S A you will forego the ability to deduct the premiums as a before the 1040 AGI line as a SE medical insurance deduction if your consulting income is considered as self employment income. If your consulting income is on a W-2 this would not be applicable.
My guess from your comments is that your 2023 taxable income may be less than in 2022. If so, you may have a tax arbitrage opportunity to make a 2023 IRA distribution to fund a 2022 IRA contribution for you and or your wife if your 2022 taxable income permits. This is something you can decide after year end by the un-extended 2022 return due date unlike H S A distributions which are reported in the the year they occur.
Thanks William. I was not aware of the proposed HSA legislation. I know a lot of folks who have been saving in an HSA and would be surprised if Medicare expense is disallowed.
The IRA arbitrage is a great idea. I always look for year over year opportunities like that. In years past I’ve used used my solo 401k in a similar fashion, making a contribution by the return date based on the previous year’s income and taxes. For some reason, a lot of the government proposals and tests I work on happen in the 4th quarter (often delayed from much earlier) and the income isn’t realized till late in the year. I’m in that situation now – waiting for a NASA RFP to come out. It was originally planned for Fall 2021!
RFP’s in the fourth quarter of the calendar year may allow the government to delay having to recognize the expense till the following year. Much like the estimated tax payment due date where estimated taxes used to be paid based on a calendar quarter, but in the 60’s the Oct due date was moved back to Sept to pull the third quarter cash receipts into the previous federal budget year which begins on Oct 1 every year, allowing the federal government to begin the year with a current influx of cash.
One thing to consider is to keep the SS @ 70 and in the meantime use the deferred dollar amounts to convert some of your IRA funds to a Roth. That will help reduce your RMDs after 72. It’s a long game…
Thanks Stu. I look at Roth conversions every year and make a decision based on that year’s financials. We will likely do one in December this year (conversions are due by December 31, unlike qualified plan contributions which can be done up to April 15.)
Well thought out process. I would question the annuity as it easy enough to construct a 5 year T-bill ladder within your IRA brokerage account that will yield more. The Roth withdrawals create missed opportunities to generate tax free earnings vs, the taxable savings that remain. But that is judgement and I can’t argue your choices. Being self employed, you will have to call some audibles as your income fluctuates. I try to spread taxable decisions across the year and preferably to year end so I don’t get into a higher bracket. I bet you have a good model for that!
Harold, thanks for the kind words. I’ve chosen not to go the annuity route. I have bought some T-bills and have the rest in a short-term bond fund for now. I have a pretty detailed spread I use to track income and taxes throughout the year. I’ve developed it over the lat five years to help keep track of required estimated taxes, and make decisions on what to save in my solo 401k. I have until April 15 to pull that lever, so I can do my first-cut taxes and still make changes that help. The Roth Withdrawals will be a game-time decision also – I’ll track income and taxes and see if it makes sense, or just go ahead and pay NJ their due!
Being a retired engineer I like your thought process. Maybe I missed it but did you consider RMDs? Maybe draw further down now on taxable on IRA / 401 k distributions now vs when you have to take them which may push you into a higher tax bracket, vs delaying your wife’s SS benefit to age 70? Also the on line planning tools several mention, do these offer modeling benefits vs what my wealth planner at Fidelity can offer using their Monte Carlo modeling?
I’m not sure I buy that today’s interest rates make holding cash more attractive. Back when you could get no more than 0.5% return on high yield savings accounts or CD’s inflation was at 2%. So your net loss in buying power on a cash account, ignoring the fact that you pay taxes on interest but can’t deduct inflation, was a negative 1.5%. Now with inflation at 8% and high yield savings accounts paying 4.5% you are losing 3.5% net. Seems to me higher interest returns from cash accounts are lagging higher inflation rates and the higher they get the worse idea going to cash is? The only thing I’ve got money in that is coming close to staying even with inflation right now is iBonds.
Hi, Richard. Thanks for outlining your thoughts on this, especially the tax considerations.
You may wish to check my math on this, and perhaps I’m overlooking something (state taxes on IRA withdrawals?) — but I think you can do better without the fixed-term annuity, setting up your own ladder of CDs at current interest rates in your IRA and drawing from them as they come due. You would not only have the benefit of the $42,000 a year, but a little left over in the IRA at the end of five years.
I went to the Immediate Annuties website and it showed essentially the same numbers as what you showed. For a $190,000 investment, $3505/month for 5 years, which gives an ending value of $210,300. This calculates to a CAGR of just 2.05%, if I have done the calculation correctly. (There are a number of online calculators available to calculate CAGR.)
My current bank savings account pays 3.6% and I can withdraw as much or as little as I want at any time. Laddered CDs or treasuries would pay even more. Also, all are backed by the government and an insurance company could theoretically go out of business. (Not sure of the AMBest rating of the companies because they are not displayed, just the numbers.)
In other words, I am not sure what the advantage of putting money into an annuity like this is, but perhaps I am missing something critical in my analysis.
You did the calculation correctly, but I’m not sure CAGR is the right metric to compare an annuity to a savings account or CD. CAGR is defined as ” the rate of return required to grow an investment from its beginning balance to its ending balance”. This assumes earnings were reinvested at the end of each period. This is not how an annuity works. BankRate has an annuity calculator that shows the interest (or growth ) rate is 4.21%. I got the same answer from Excel. I think that is the right value to compare to a CD or savings interest rate.
One confusion is that Insurance companies sometimes quote an “annuity rate”. This is the yearly income / amount invested. For my example the value is $42,049/$190,000, or about 22%. That merely shows that you are getting little more than 1/5 of the amount invested each of the 5 years.
Hope this helps,
That makes a lot of sense. I am just so used to using CAGR for stock and bond investments, but I should have realized that it would be different. (I know that bank accounts use APY.) Realistically, I should have just done an excel table with an initial contribution, growing at a set APY, with the same distribution as the annuity example, and saw which came out ahead. I was being lazy though. Thanks for the information and helpful discussion! Looking forward to future articles!
Your comment caused me to think about something I haven’t thought about for a while… All states have a “Guaranty Fund” that pays out when and insurance company becomes insolvent. For New Jersey, the amount is as follows:
$100,000 (if the annuity is deferred) or $500,000 (if the annuity is in payout status)
Check out other states at this link:
That is interesting and something I believe I have heard before. I would assume that insolvency might not always lead to ironclad protections/reimbursements just based on the fact that different insurance companies have different AMBest ratings (A++, A+, A, B++, etc.) which lead to different rates being paid, much in the same way that corporate bonds with lower ratings must pay more due to a higher chance of not paying out. I always kind of assumed it was like when a company goes insolvent with pension obligations and the state backstop pays some lesser percentage, but it may work completely differently.
The Guaranty Fund is funded by the insurance companies themselves. There should be money available for insolvency payments. Interestingly, GEICO, the Berkshire Hathaway company almost went bankrupt in the 1970s (before it was part of Berkshire). Several companies got together and essentially bailed out GEICO. Buffett started buying GEICO stock when it was in the toilet. Bottom line: The Best Ratings should affect the Guaranty Fund payment. If your house burns to the ground, you’ll get the insured amount regardless of the company rating. The downside is it will take longer and be more of a hassle.
Hi Richard, how are you calculating a 4.8% yield on BSV? I’m annualizing the most recent month’s dividend of 0.112 to get a current yield of 1.8%.
This is the SEC yield. It is the standard way to compare bond funds. Here is a good explanation.
The yield is from Vanguard’s site:
As of this morning, it’s at 4.74%.
I’m with Ken in not understanding the yield on BSV. Rick, I see Vanguard’s SEC yield, but it’s still not making sense to me. The last 12 months of distributions add up to $1.258 with the NAV at $75.20 or the market price at $75.25. Either way that’s a yield of about 1.67%. Could there be an error in the reported SEC yield?
As the footnote on the 4.74% yield says, “BASED ON HOLDINGS’ YIELD TO MATURITY FOR PRIOR 30 DAYS;DISTRIBUTION MAY DIFFER.” Remember, yields have soared this year, especially at the short end of the curve. A two-year Treasury is current yielding almost 4.4%.
Ah, thanks for the clarification. I think I understand. Would that mean that one should expect the next monthly distribution to be about $0.29-0.30/share?
I don’t think you can assume that. But if the bonds held by the fund have a yield to maturity of 4.74% and you hold the fund for almost three years, which approximates the average yield to maturity of its holdings, your total return — share price change plus income — should be around 4.7%.
Hey Richard, if I didn’t know for sure, I’d bet a lot of money on you being an engineer. I used to work with hundreds of engineers and their ability to analyze a decision both amazed me and drove me nuts.
Sure it’s the right way to help come up with the best decision, but I’ve seen it create analysis paralysis too. In any case you certainly did a thorough job.
At the risk of being chastised yet again by readers, do you feel it relevant to even think about maximizing the lifetime Social Security benefit? Seems your analysis is rightly focused on current income needs.
Have you considered Medigap costs and IRMAA Medicare premiums?
I was watching a YouTube video on taking SS and it emphasized the opportunity cost – the lost growth in investments being used as income while delaying SS benefit. I was wondering if that was part of your analysis.
Thanks Dick, I have seen, and been guilty of, Paralysis by Analysis many times.
One of the challenges of complex analyses is what to solve for. You consistently, and correctly, identify sufficient income as the most important aspect of a retirement plan. I completely agree with that, and my goal in performing these types of analyses is to solve for the optimal, but reasonable, way to achieve that plan.
My expense model includes Federal and state taxes, health insurance costs (including Medicare, Medigap, Part D, and IRMAA costs), and my best estimates of our annual and desired expenses.
Things life SS lifetime benefits, taxes, are just data points to be evaluated. I use them with all the other considerations (like where we want to live, how much we want tot travel, …) to make our decisions.
The tradeoff between delaying SS and using other assets, and taking it earlier and investing, is something I think a lot about. I think it might be with an article
“Paralysis by Analysis”
My head is spinning after reading this great article. I never thought retirement would/could create so many money decisions.
And that’s this group, who apparently can and will do some analysis. I wonder about the “great majority” out there who just make a quick decision (that impacts the rest of their life) and goes on.
Rick, thoughtful discussion of retirement planning issues. Thanks. I especially appreciate your comment about taxes being a civic duty. I’d add that paying taxes – something no one likes to do – maintains strong societies and enables us care for those less fortunate than us as well as repair roads, fund libraries, and much more.
Thank you Peter
Richard, great description of your analysis. I have two questions: 1) If your 5-year annuity pays all 60 months regardless of your survival, why does your age matter at all in the premium quotes? I think these are called Multi-Year Guaranteed Annuities (MYGAs), but anyone please feel free to correct me if I’m not clear on this. 2) Have you considered using MyWealthTrace.com retirement and financial planning software to solve the mathematical part of your optimal withdrawal strategy, including state taxes? I haven’t purchased or used WealthTrace myself (yet), but my understanding is this is the most powerful planning software available to both DIY investors as well as professional financial planners. It was developed by a CFA who offers personal-professional “technical support” while using this software is his own financial planning practice. I’d love to hear from any HumbleDollar readers familiar with WealthTrace or who already use it. It costs between $189-$229/year. Maybe HumbleDollar readers could arrange for a recurring “group discount” at a much lower cost ($60-$120/year, or $5-$10/mo?) if this is a solid product.
Dan, thanks for reading and the kind comment. The answer to your first question is it doesn’t. I checked Fidelity and Immediate Annuity and for a 5-year period certain annuity I get the same answer for a 60, 62, and 65 year old. It also didn’t matter if you are male or female, or what state.
I was looking at period certain immediate annuities. As far as I can tell, MYGAs have an accumulation period with surrender charges. I’m not that familiar with them.
I am not familiar with WealthTrace. I look at the web site and it does look pretty powerful. I haves used MaxiFi extensively, and have tried NewRetirement’s tool. I also used MoneyGuidePro during my CFP coursework. WealthTrace seems to perform a traditional retirement income, expense, and portfolio value projection calculation. The additional feature seems to be the “what-if” scenarios and integration with your financial accounts.
MaxiFi is a very powerful tool with detailed SS, and tax models. You can also model many what if scenarios, as well as future events like hoe sales, college, LTC, and others. The biggest difference is that MaxiFi solves for your optimum “utility” or standard of living. One of the challenges of retirement income planning is what variable to measure and compare when you evaluate different scenarios. Standard of living is a consistent and easily understandable measurand to compare.