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Survivor Benefit flexibility

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Many of the Social Security rule changes that have been put into place in the past several years have removed flexibility in Social Security claiming strategies. However, Survivor Benefits, coordinated with your own retirement benefit (if you’re a surviving spouse or surviving divorced spouse), remain as one of the last bastions of flexibility for claiming strategies.

Survivor benefit first, retirement benefit later

As we’ve discussed in other articles, claiming Survivor benefits early and then claiming your own Retirement benefit later provides one flexible claiming strategy that you might be able to employ.

For example, Dina is divorced (after more than 10 years), unmarried, age 60, and her ex-husband passed away recently. Dina could file for and receive a Survivor benefit based on her late ex-husband’s record right away, and collect that benefit for a while. Then, at any point she could switch over to her own retirement benefit if it is larger than the Survivor benefit, and continue collecting that benefit.

This strategy works well if the surviving spouse has earned his or her own retirement benefit during his or her career, and at some point the retirement benefit will grow to a point when it’s greater than the Survivor benefit. This crossover might occur within a few months after she starts taking the Survivor benefit, or at any point along the spectrum between start of Survivor benefits and his or her age 70.

In Dina’s case, her own retirement benefit will be greater than the Survivor benefit at once when she reaches age 62. (Keep in mind, if she’s started the Survivor benefit at age 60 this benefit will be reduced; likewise if she starts her own benefit at age 62 the retirement benefit will also be reduced.) Dina could start receiving the larger retirement benefit at age 62, or at any point through the years up to age 70 if she wants.

When Dina starts receiving the retirement benefit, since the retirement benefit is larger than the Survivor benefit, the Survivor benefit will end. Technically (and this is important to the rules) the Survivor benefit will terminate if Dina’s PIA is larger than the PIA upon which her Survivor benefit is calculated. It’s a technicality, because generally if Dina’s reduced retirement benefit is greater than the reduced Survivor benefit, more than likely the PIA of each benefit will correspond in size.

At any rate, that’s how the “Survivor benefit first, retirement benefit later” strategy works. The key to this strategy is that starting the Survivor benefit early has no impact on Dina’s later ability to file for and receive a retirement benefit. The delayed receipt of the retirement benefit is added to Dina’s record as if she had not filed for a previous benefit (in other words, no deeming is applied).

Retirement benefit first, Survivor benefit later

This strategy can work in the reverse as well. Dina could wait until her age 62 and start receiving her own retirement benefit, reduced due to the early filing. Then she could wait until as late as her Full Retirement Age (for survivor benefits, slightly different from the regular FRA) and file for the Survivor benefit. This filing would be unaffected by the early filing for her retirement benefit.

Survivor benefit first, then retirement benefit, then Survivor benefit again

You might think that this is where the flexibility story ends, but you’d be wrong. There is one other strategy that the rules allow. In Dina’s case, she could start taking the Survivor benefit at age 60 (reduced to the minimum), and then at or after age 62 (but before her Survivor benefit FRA) file for her own retirement benefit. If, upon filing for her retirement benefit the retirement PIA is greater than the Survivor benefit PIA, the Survivor benefit will terminate at this point, as discussed earlier.

Now is when this final flexibility option comes into play. If it turns out that Dina’s Survivor benefit might at some point become larger than her Retirement benefit, she has the option to re-entitle the Survivor benefit. (Reentitlement is SSA’s term for filing for and receiving a benefit that had been received previously, but had terminated.)

The numbers have to work out in her favor, but follow this: starting her Survivor benefit at age 60 resulted in a reduction of the maximum amount, 28.5%, to Dina’s Survivor benefit. This is based on her Full Retirement Age of 67, which means a reduction period of 84 months (7 years).

But if she starts her own retirement benefit at age 62, thus terminating the Survivor benefit, she has the option to re-entitle the Survivor benefit, with the calculation eliminating those months during which she was receiving the retirement benefit (and the Survivor benefit was terminated). So if she waits until her FRA for Survivor benefits, her newly re-entitled Survivor benefit would be calculated based on a reduction of only 24 months – those months that she had collected earlier. Full Retirement Age is the latest that it makes sense to apply this re-entitlement, as beyond FRA the Survivor benefit will not increase except for annual COLAs. (For the rules geeks in the audience, see POMS RS 00615.301A.2, second bullet point for the explanation and another example.)

So instead of an 84 month reduction of 28.5%, Dina’s new Survivor benefit would only be reduced by 24 months, which calculates to a reduction of 8.14%. If, for example, her original reduced Survivor benefit was $1,000, this adjustment upon re-entitlement would bring the benefit up to $1,285, plus the COLAs from the intervening years.

Not a lot of surviving spouses and ex-spouses will have this flexibility available to them, but for the ones that do have it, this strategy can help out quite a lot, I imagine.

The strategy outlined above only applies in a situation where the Survivor benefit that is re-entitled is the same Survivor benefit that had been previously received. Otherwise, if a new Survivor benefit (based on the record a different spouse, also deceased) is applied for, it will be treated as the first time you’ve filed for a Survivor benefit. The prior reduced Survivor benefit has no bearing on the amount of this new Survivor benefit.

This one doesn’t work in vice versa

It’s critical to note that the above strategy (Survivor benefit first, then retirement benefit, then Survivor benefit again) does not work in the reverse. Dina could not, for example, begin her retirement benefit at age 62, then switch to Survivor benefits at (for example) 64, and then switch back to retirement benefits later on. This is because of the technical matter that I mentioned above, where the Survivor benefit becomes terminated upon receipt of a higher retirement benefit. The retirement benefit does not similarly terminate when a higher Survivor benefit starts up. In that case, the Survivor benefit (if higher than the retirement benefit) becomes an “excess” benefit, and the difference between the retirement benefit to the Survivor benefit is simply added to the retirement benefit.

Disability Benefits at Retirement Age

my-that-cake-is-short

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What options do you have available to you when you’ve been receiving Social Security disability payments – and you’re nearing Full Retirement Age (FRA)? A reader recently asked this question as she and her husband are facing decisions with just such a situation…

Disability Benefits at Retirement Age

As you reach FRA, your Social Security Disability Benefit will automatically convert over to a Retirement Benefit, at the same amount.

What does this mean? Essentially, once you reach FRA, since you’re now on a Retirement Benefit, you have all of the features available to you as if you had not received any benefit prior to this point and you’re now retired. So your spouse can collect Spousal Benefits based on your Primary Insurance Amount; Survivor Benefits are also available; and you can choose to Suspend your benefits at FRA (no need to File before suspending, you have effectively filed when your Disability Benefit converted to Retirement Benefits).

Just keep in mind that by suspending your benefits, you’re suspending all benefits associated with your record. Any spousal or dependent’s benefit will likewise be suspended and not paid.

By suspending, you can earn Delayed Retirement Credits (DRCs) of 8% per year up to age 70, which will permanently increase your own benefit and your spouse’s potential future Survivor Benefit.

Obviously, there is no requirement for you to change anything at all once you reach FRA – you can continue receiving the Retirement Benefit the same as you have been receiving the Disability Benefit up to this point.

It’s an unusual situation, but something to keep in mind if you happen to be facing this circumstance.

FRA for Retirement Benefits vs FRA for Survivor Benefits

As mentioned in many articles on this site, there is a difference between the Full Retirement Age (FRA) for Social Security Retirement Benefits and the FRA for Social Security Survivor Benefits.

This is due to the way that the language of the reductions rules is written. The rules are written based upon the earliest age that you are eligible for each type of benefit. Since Survivor benefits are available as early as age 60 under common circumstances, and Retirement Benefits are available at age 62 at the earliest, there is a two-year offset between the two FRA tables, as illustrated below:

Full Retirement Age – Retirement Benefits
Born in: Full Retirement Age (FRA) is:
1943-1954 66
1955 66y, 2m
1956 66y, 4m
1957 66y, 6m
1958 66y, 8m
1959 66y, 10m
1960 or later 67

Note that each “Born in” year is two years later than the complementary year in the Retirement benefit table.

Full Retirement Age – Survivor Benefits
Born in: Full Retirement Age (FRA) is:
1945-1956 66
1957 66y, 2m
1958 66y, 4m
1959 66y, 6m
1960 66y, 8m
1961 66y, 10m
1962 or later 67

How does WEP work for a lump-sum pension payout?

lump-sum clouds

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In other articles we’ve covered how a typical annuitized pension triggers the Windfall Elimination Provision (WEP), but how about a lump-sum pension payout? How does this work? How is the amount of the “pension” determined for the WEP calculation?

This type of lump-sum payment can be either from a defined benefit plan such as the typical annuity pension, or it can be from a defined contribution plan (like a 401(k), 403(b), or 457 plan). For simplicity, since the rules are the same either way, we’ll refer to both defined contribution and defined benefit plans in this article as “pension plans”.

We know from other study of WEP that the maximum WEP reduction can be limited by the monthly amount of your pension benefits. So we need to determine what a lump-sum payment at a particular age is equivalent to in terms of a monthly payment. Social Security has a way to perform this calculation.

In POMS RS 00605.364 Determining Pension Applicability, Eligibility Date, and Monthly Amount(5) is an actuarial table that is used to convert a lump-sum pension payment into a monthly equivalent. To use the table, find the age that you are when you are taking the lump-sum payment in the left column. Then, assuming your lump-sum is received in the current year, go to the next column to the right for the divisor factor. (This is an important number for another reason that we’ll cover later.) If you received the lump-sum at some point in the past, review the various column headings to see if one of those is more appropriate for your circumstances, and use the divisor factor from the applicable column.

Divide the lump-sum payment by the divisor factor for your age when the lump sum is received. This is the monthly equivalent of your lump-sum payment. This can be important to help determine the maximum WEP reduction, since WEP reduction cannot be more than 50% of the monthly pension payment, if that amount is less than the bend point maximum.

To work through an example, let’s say we have a lump-sum pension payment in the amount of $250,000, and we’re receiving this lump-sum payment in 2022 at the age of 65. Going to the actuarial table, we find that our divisor factor is 180.3. Dividing $250,000 by 180.3 gives us $1,386.58 as the monthly equivalent benefit amount. 

When we look at the WEP calculation for this individual (age 65 in 2022), we see that the maximum WEP reduction based on bend points is $463, so the monthly equivalent doesn’t factor into the calculation for this individual. 

On the other hand, let’s say the lump-sum payment is $50,000 (other factors remaining the same). This gives us a monthly equivalent of $277.32. Since 50% of this amount is far less than the maximum WEP based on bend points, this means that the maximum WEP reduction in this scenario is $138.66.

Earlier I mentioned that the divisor factor is important for another reason beyond calculating the monthly equivalent pension amount from your lump-sum payment. Here’s the reason: the divisor factor is a determination of your lifespan, in months, from the current year. From our example, the divisor factor was 180.3 – this means the actuarial lifespan of the individual at age 65 is 15 years (180 months and some change). 

If our example individual lived more than 15 (and some change) years, then WEP will no longer apply to this individual. Effectively he has lived past the monthly payout equivalent, and so the WEP reduction will be removed from his PIA calculation at that point.

Your Social Security Benefits Statement

ss statementBack in the olden days, we all received an annual statement from the Social Security Administration detailing your benefits projected to your potential retirement age(s). Nowadays you can go online (www.SocialSecurity.gov) and request a current statement at any time. If you haven’t gone online for your statement and you’re at least age 60, you should receive a mailed copy of the statement annually until you start receiving benefits.

While the statement is designed to be pretty well self-explanatory, I thought it might be beneficial to review the statement so that you know what the statement is telling you. The statement has been redesigned recently, so it will look considerably different from the old school statement.

First Page

The first page of the statement contains a host of really important information for your benefit. Under “Retirement Benefits” you’ll find your Full Retirement Age (based on your date of birth), and to the right of this paragraph you’ll find a chart with the estimated monthly benefit that you are eligible for, with the assumption that you continue to earn at the same rate as your most recently-reported earnings.

Below “Retirement Benefits” you’ll find information about your “Disability Benefits”, including the amount that you could receive if you became disabled right now.

Next on the page is the estimate of “Survivor Benefits” that could be available to your spouse and/or dependents upon your demise.

To the right (below the Retirement Benefit chart) is the information about your eligibility for Medicare benefits. This includes your age for eligibility and your current status – whether you’ve earned enough credits for Medicare eligibility.

Second Page

The Second Page of the statement lists out the details of your Earnings Record in the left column. This section is important to review carefully… you should review the earnings listed for each year against your tax records or W2 statements, to make sure that the information the SSA has is correct. In addition to reviewing for correctness, you should look over your record and note the “zero” earnings years, as well as years that you earned considerably less than what you earned (or are earning) in later years.

There are details on how to report any inaccuracies that you might find on your statement. It’s much easier to resolve things earlier in the process rather than later – when you’re possibly under the gun about applying for your benefits.

It should be noted that in the interest of saving space, your earliest earnings records are combined by decade. You can review each individual year’s earnings record online in your my Social Security account.

As we’ve discussed in the past, your benefits are based upon your 35 highest earning years. If you have had some “zero” years in the past or some very low earnings years, you can expect for your estimated benefit to reflect any increases that the current year’s income represents over your earlier low earnings or zero years. This only becomes significant once you have a full 35 year record in the system.

Another key here is that your projected benefits listed on the first page are based upon your earnings remaining the same until your projected retirement age(s). If you choose, for example, to retire at age 55 and have no earnings subject to Social Security withholding, your projected benefit could be reduced since those years projected at your current earning level will actually be “zero” years. Alternatively, your earnings might not be zero but much lower than projected if you have a lower salaried job during that period. This reduction is in addition to any actuarial reductions that you would experience if you choose to take retirement benefits before FRA.

There are tools and calculators available on my Social Security to help you with projecting your potential benefit with more accuracy. In addition, there are many tools available, some free and some paid, all around the internet.

If you have gaps showing in your earnings history, you may have had a job that was not covered by Social Security, so you will be interested in knowing how the Windfall Elimination Provision (WEP) affects you, and how the Government Pension Offset (GPO) may affect your family or benefits that you may be eligible for from your spouse. This is briefly covered in the right column, and if it is apparent that you might be impacted by WEP or GPO, there may be an additional fact sheet attached to your statement.

The bottom of the left column shows how much tax you and your employer have paid into the system over the years – both the Social Security system and Medicare system. This can be an eye-opener… quite often we don’t realize how the money we’ve paid in can stack up!

Third Page (there’s a third one?)

The Third Page of the statement lists Important Things to Know about Your Social Security Benefits. Hopefully you already know these facts, but just in case you don’t, it makes good sense to review them periodically. (For some folks, this list is provided on the second page of the statement and the overall statement is only two pages in length. I think most standard statements are three pages long these days, along with addenda listed below.)

Addenda

Included with your statement could be several addenda, depending on your circumstances. Among the possible addenda for your statement could be:

  • Retirement Ready Fact Sheet (everyone should get one of these, adjusted messages depending on your age)
  • Social Security Basics for New Workers (when you’re just starting out)
  • How You Become Eligible For Benefits (you’ll receive this until you have the required 40 quarters of coverage)
  • Additional Work Can Increase Your Future Benefits (you may receive this if you’ve begun recording zero years)
  • You Have Earnings Not Covered By Social Security (You will receive this if your earnings record indicates some of your earnings was not covered. This doesn’t mean WEP or GPO is part of your future, just that they might impact your future benefits.)
  • Medicare Ready (when you’re approaching age 65)
  • Supplemental Security Income And Other Benefits (you may receive this addendum if it appears by the facts that you might be eligible for SSI or other programs)

What Your Social Security Statement Is Telling You

making a statement

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There is a portion of your Social Security statement that is often a source of misunderstanding. The portion I’m talking about is the projection chart on the right-hand side of the first page.

If you’ll take a look at this portion of the statement, you’ll see a projection of your Social Security retirement benefits, at each age between 62 (unless you’re already past that age) up to age 70. Also listed elsewhere on the statement are the amounts that you would receive for Disability Benefits, as well as amounts that your family would receive upon your death as survivors.

What gets missed for many folks is the last line of the corresponding paragraph (just left of the chart) which states:

These personalized estimates are based on your earnings to date and assume you continue to earn $xx,xxx per year until you start your benefits.

With that short phrase comes a great deal of confusion and misunderstanding. This statement means that, assuming that you are something less than age 70, the statement reflects an assumption of your future earnings from now until those projected ages listed in the chart. Those amounts provided are based upon the assumption that you will continue earning at the rate most recently reported to SSA, usually what was on your tax return in the previous year.

If, for example, you chose to stop working at age 62 and delay receiving benefits until FRA, the benefit that you’ll receive will likely be less than the amount shown on your statement, because you did not continue earning at your current rate to FRA, as the projection assumes.

Another example is where you continue working, but your income has been reduced, due to layoff or other dramatic change in your employment. With the “great resignation” going on over the past few years, it’s not hard to imagine a situation where this might be the case.

Your future income might also be higher than the assumption, which could potentially result in a higher benefit than the chart indicates.

There are several calculators available on the Social Security website that can help you to get a clearer picture of your actual benefit if your projected earnings will be something different than what you’ve experienced up to the present (or actually, up to last year, since that’s all the more that is generally covered with the statement).

Staging Your Roth IRA Conversion

staging

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So you have a substantial IRA (or several IRAs), and you’ve retired. For the first time since you started your career, you’re in a low tax bracket. You’re not age 72 just yet, so you don’t need to concern yourself with Required Minimum Distributions (RMDs).

But then again, maybe you should concern yourself with those Required Minimum distributions…?

Think about it – you’re in a good place, tax-wise, and your IRA money is bound to continue to grow over time. You are getting along just fine with your pension, Social Security, and other investment income. This is the perfect time to strategically reduce your future tax bite.

Staging the Roth IRA Conversion

Let’s say for example that your taxable income puts you in one of the lowest tax brackets… say 22% or less. You have some “headroom” left in the bracket to spare, meaning that you could realize some additional income without bumping up to the next bracket. The amount you’re converting in any given year doesn’t seem like a lot, but since you’ve got a few years before you reach age 72, little by little you could be reducing (or eliminating) the amount of RMDs that you’ll be forced to take later on.

Each year you can convert an amount from your IRA to a Roth IRA that will bring you just up to the top of your tax bracket (but not over). By doing this, you’re controlling the flow of the money at a point when you can afford to, rather than having income forced on you when you don’t want it.

Then, when you reach age 72, you have either reduced your IRA down to an easily-manageable amount for RMDs, or completely eliminated the IRA altogether, and the RMDs with it! If that’s the case you don’t have to worry about taking RMDs from the funds that you’ve transferred (converted) to the Roth IRA – and if you want to take money out of the Roth IRA, you can do so tax free!

The funds in the Roth IRA can continue growing over time, and you don’t have to worry about paying tax on the growth at all. You paid tax at today’s (assumedly lower) rates and today’s value of the old IRA account before all of that future growth occurred.

If you don’t have a need for the funds in the Roth IRA, you will never be required to take the money out – and your heirs can stretch out the tax-deferral over many years. This can amount to some very substantial tax savings!

The Downsides

There are a few downsides to such a strategy, as you might have guessed. As you convert funds from your IRA to your Roth IRA, the increase in your taxable income in any given year has some additional impacts that you need to keep in mind. Increasing taxable income can increase the amount of your Social Security benefit that is taxed, for one thing.

Another is that, as your income increases, so does your Adjusted Gross Income (AGI), which controls a lot of your deductions, such as medical expenses. Your medical expense deduction is limited to the amount greater than 7.5% of your AGI. If you increase your AGI by converting IRA funds to a Roth IRA, you’ll effectively reduce the amount of your medical deduction by 7.5% of the amount you convert.

In addition, you need to come up with a source of money to pay the tax – either from your IRA (thus reducing the potential Roth IRA and its potential for growth), or from other investment accounts, which will reduce the available funds from there.

Medicare premiums could be impacted by a Roth conversion as well, but if you’re in the 22% tax bracket and you stay below that threshold, you shouldn’t have any issue with IRMAA increases to Medicare premiums.

A Good Reason to Not Convert to Roth

While there are many reasons that it may be in your best interest to pay tax and convert funds from a traditional IRA to a Roth IRA, there are a few situations that you might want to keep in mind as you consider converting.

I covered Three Reasons You May Not Want to Convert to a Roth IRA in an earlier article, and here we’ll be talking about another – the probability of paying medical expenses from your traditional IRA.

Under current tax law, you are allowed to deduct medical expenses to the extent that the expenses exceed 7.5% of your Adjusted Gross Income (AGI). In effect, if you utilized IRA distributions to pay for these medical expenses, everything above 7.5% of your AGI can be tax free after deduction. This is much better than paying up to 35% on a Roth conversion and then using those funds later at no tax. Of course, if your medical expenses are something less than 7.5% of your AGI, or a relatively insignificant amount over that level, it might not make as much sense.

Since many of us can expect to pay a considerable amount for future medical expenses – whether for doctors and hospitals, or for nursing home costs, or even for in-home nursing care – it might make good sense to maintain a balance in a traditional IRA rather than converting all of it to a Roth IRA.

Just another item to consider as you think about converting money from your traditional IRA to a Roth IRA.

Earnings Tests in the Year You Begin Benefits

limits

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As you may already be aware, there are limits to the amounts that you can earn while receiving Social Security benefits. This factor is covered in detail in the article at this link – Social Security Earnings Tests.

What isn’t clear is just how these earnings impact your benefits in the year that you first begin receiving your Social Security benefits…

If you’re at FRA (Full Retirement Age) or later when you begin receiving your benefits, you have no earnings limit at all. And if you’re younger when you begin your benefits (as the earlier article outlined) up to the year you will reach FRA your benefit will be reduced by $1 for every $2 that you earn over the limit ($19,560 for 2022). During the year you are FRA (before you reach the actual FRA), your benefit will be reduced by $1 for every $3 that you earn over the FRA limit ($51,960 for 2022).

What’s important to know is that, no matter when you start your benefits, you can earn as much as you like, prior to starting your benefits. The earnings limits only apply AFTER you’ve begun receiving your benefits, and then only if you’re younger than FRA when you commence receiving benefits. In the case of the years prior to FRA, your benefit will be reduced when your monthly income is greater than $1,630 per month, for every month that you are receiving Social Security benefits, but only if your total income for the year is more than $19,560. This is just a pro-rated application of the annual limit of $19,560 for 2022, and it only applies during your first year of receiving benefits.

The same pro-rate method is applied for the year of FRA – the monthly limit is $4,330 for 2022. This only applies when you start benefits during that year you’ll reach FRA.

And as stated before, once you get to FRA, there is no earnings limit at all.

Hope this clears up the Earnings Limit issue during the year you begin receiving benefits.

Determining Your MAGI

MAGI

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There are income limits for contributing to an IRA (traditional and Roth). These limits, along with your filing status and your Modified Adjusted Gross Income (MAGI) are important factors in setting the limits for Traditional IRAs, as there is the issue of deductibility at stake.

In order to fully understand the limitations, you also need to understand what makes up your Modified AGI (MAGI).  The MAGI is calculated as follows:

  1. Start with your Adjusted Gross Income (line 11, Form 1040, Form 1040SR or Form 1040NR)
  2. Add back in your IRA deduction amount (line 20 on Schedule 1)
  3. Add back in your student loan interest (line 21 on Schedule 1)
  4. Add back any foreign earned income and/or housing exclusions from line 45 of Form 2555
  5. Add back any foreign housing deduction from line 50 of Form 2555
  6. Add back any excluded qualified savings bond interest from Form 8815 line 14
  7. Add back in any excluded employer-provided adoption benefits shown on line 28, Form 8839

The total of these seven items listed above make up your Modified Adjusted Gross Income, or MAGI.

The MAGI is used to determine the amount, if any, of your Traditional IRA contribution that is deductible if you or your spouse is covered by an employer retirement plan.

For a Roth IRA contribution, your MAGI is calculated as follows:

  1. Start with your Adjusted Gross Income (line 11, Form 1040, Form 1040SR or Form 1040NR)
  2. Subtract any income from the AGI that is the result of IRA funds to a Roth IRA, or from a rollover conversion from a qualified employer retirement plan to a Roth IRA
  3. Add back in your IRA deduction amount (line 20 on Schedule 1)
  4. Add back in your student loan interest (line 21 on Schedule 1)
  5. Add back any foreign earned income and/or housing exclusions from line 45 of Form 2555
  6. Add back any foreign housing deduction from line 50 of Form 2555
  7. Add back any excluded qualified savings bond interest from Form 8815 line 14
  8. Add back in any excluded employer-provided adoption benefits shown on line 28, Form 8839

Tallying up those 8 items will result in your MAGI for the purpose of a Roth IRA contribution.

For the current MAGI limits for each type of contribution, see IRS Publication 590A.

PS – Reader Paul correctly points out that there are other MAGI calculations (his example was for IRMAA) that are slightly different from the above MAGI calculations. Pay close attention to the requirements for the MAGI that you’re looking to calculate for your specific purposes.

IRA Cross Loans – Don’t Even Think About It

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Once again in the category of terrible things you can attempt to do with your IRA, there is the concept of a “cross loan” from your IRA to another, unrelated party.

You know from previous articles that it’s not allowable to transact business with disqualified persons. Therefore, you can not take a loan from your IRA to finance your business, or your brother’s business (among others). But what if you came to an agreement with someone else not related to you in any way, who is not a disqualified person, to loan money from your IRA to finance her business, while she loans money from her IRA to finance yours? Whatever could go wrong with this arrangement?

While the technical provision of transacting business with a disqualified person has been avoided, there’s a small problem with the plan. There is another test that prohibits the IRA owner from receiving an indirect benefit from a transaction. In the case of the cross loans, there is an indirect benefit in that one loan facilitates the other – and the IRS would figger this out before you could say “Bob’s your uncle”.

Entering into such a series of loans would most likely result in both IRAs being disqualified and taxable immediately. It should be noted that this would also be considered a prohibited transaction if the second loan was from another source besides an IRA, since the indirect benefit would still have come into play.

IRA Charitable Distributions – If You’re Less Than Age 70½

pussywillows

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We discussed the IRA Qualified Charitable Distribution (QCD) option for folks age 70½ or better in other articles. It’s possible from those articles that you got the impression that if you are younger than 70½, you are not able to make charitable contributions with money from your IRA. Nothing could be further from the truth! You can always make charitable contributions of any money you wish… the question is, what will such a move do for you tax-wise?

First of all, even though the age for RMD has increased to 72, the age for Qualified Charitable Distributions remains at 70½, so don’t get these two confused.

If you’re under age 70½

You can make charitable contributions from your IRA account – the only problem is that you must first count the distribution from your IRA as income, and then you account for the charitable contribution among your Schedule A Itemized Deductions. The end result is the same, right? Au contraire, mon ami.

The problem is that, by having to count your IRA distribution as income, you will increase your Adjusted Gross Income (and therefore your Modified AGI), both of which can have a significant impact on other items on your tax return.

Example

Let’s run through an example: you’re age 72, have an IRA worth $50,000, and you want to contribute the entire amount to your favorite charity. Your other income, along with your spouse’s income, totals $70,000. Included among your tax return items is $10,000 in medical expenses, along with other deductions (real estate tax, home mortgage interest, etc.) amounting to $15,000. You had no other charitable contributions for the year.

Under the QCD rules, your AGI is $70,000. Your itemized deductions amount to $19,750 – because your medical expense deduction is limited to the amount over 7.5% of your AGI. Since 7.5% of $70,000 is $5,250; we subtract that amount from $10,000 and come up with $4,750, which we then add to the rest of your itemized deductions for a total of $19,750 in deductions. Since the standard deduction for a couple of this age is $28,700, you’d use the standard deduction.

Subtracting the standard deduction from your AGI ($70,000 minus $28,700) equals $41,300. This is your taxable income, assuming you don’t have any other deductions such as QBI. Tax on this amount is $4,545 (2022 tax tables).

If you were younger than age 70½, your AGI is $120,000. This because the IRA distribution of $50,000 is added to the rest of your income. So if you were age 65 for example, itemized deductions are now $66,000, because your medical expense deduction was reduced to $1,000 ($120,000 times 7.5% equals $9,000, subtracted from $10,000 equals $1,000). We add the rest of your itemized deductions (including the $50,000 charitable contribution deduction) and come up with $66,000 ($15,000 plus $1,000 plus $50,000).

Subtracting the itemized deductions from your AGI equals $54,000, which is your taxable income, absent any other deductions. Tax on this amount is $6,069 (2022 tax tables).

Even though you had a significant itemized deduction amount, you’re still better off if you can use the QCD. Under these rules, by not using a QCD you paid $1,524 more in taxes than you would have if you were 70½ or older and used a QCD, with otherwise all of the same circumstances. So, while it’s possible to make a charitable contribution from your IRA account when you’re younger, it’s more costly to do so. It’s also possible to make charitable contributions after age 70½ without using the QCD option, but you’re throwing tax money away – might as well take advantage of this option!

Other items affected by AGI

There are several items on your tax return that are impacted by the amount of your AGI. The AGI gets increased when you take a distribution from your IRA, unless you have the distribution treated as a QCD. Listed below are some of the more common items that are impacted:

  • taxable amount of Social Security (or Railroad Retirement) benefits
  • allowable losses from rental real estate activity with active participation
  • deductible traditional IRA and spousal IRA contributions
  • ability to contribute to a Roth IRA
  • miscellaneous itemized deductions, including non-reimbursed employee job expenses
  • and a number of miscellaneous credits

These and many other components of your tax return can be impacted by an increase in your AGI. By using the QCD option, you are avoiding this increase to AGI, which can limit these other tax benefits.

Prohibited Transactions and Disqualified Persons

prohibited by Phillip McI have covered the topic of Prohibited Transactions in an earlier article – one of the main prohibitions is that you can’t self-deal with your IRA by borrowing from, selling to, or allowing a class of persons, called Disqualified Persons, to transact business with your IRA as well.

The problem that often comes up, especially with IRAs that invest in “self-directed” activities like Real Estate, is that folks look at the list of Disqualified Persons and determine that there are other persons that they can allow to make transactions with their IRA – and that since these others are not Disqualified, the transaction will no longer be a prohibited transaction.

Let’s back up and define Disqualified Persons – this means you, as the account owner, your spouse, your parents, grandparents or other ancestors, as well as your children, grandchildren, or other descendants, as well as the spouses of any of these persons. So, for example, your step-child wouldn’t be a Disqualified Person, as long as you haven’t legally adopted the child. In addition, your siblings aren’t Disqualified Persons either, nor would your girlfriend or boyfriend be disqualified. So technically, one of these people could transact business with your IRA – as long as there is no other reason to prohibit the transaction.

The problem is, if you (or another Disqualified Person) benefit directly or indirectly from a transaction with the IRA, the transaction is prohibited – no matter who the person is that you’ve transacted with. So, for example, if you’ve invested in a condo with your IRA money, and you rent the condo out to non-related persons, you’re in good shape. But if you try to play it cute and rent the condo out to your boyfriend, and you send your children to vacation with him for three weeks in the summer, the rental transaction is prohibited since disqualified persons have benefited from it.

In this case, it’s possible that the transaction could result in a penalty, or possibly invalidating your IRA, prompting an immediate disqualification and distribution including taxes and penalties, which could be a very bad thing.

The Impact of Zero Years

zeroRemember when we talked about how your Social Security Benefit is calculated? Your highest 35 earning years during your career are put into a formula, and the earnings are indexed, then averaged by dividing the result by 420, the number of months in 35 years. And if you have less than 35 years of earnings, those years without earnings are counted as zeros…

So, you can guess what might happen when you have years with zero earnings in your record. Naturally your average is going to be reduced (perhaps dramatically) by any year when you had zero earnings.

Let’s say you have 35 years of earnings at the maximum amount, which will give you (for 2022) a FRA benefit of $3,262. But if you only had 30 years at the maximum earnings amount, your benefit would be reduced to $3,010, an annual reduction of $3,024. Taking this further, if there were only 20 years of earnings at the maximum amount, your FRA benefit would be reduced to $2,509, for an annual reduction of $9,036.

This comes up when an individual chooses to retire early, or has years in which he or she has not earned during his or her career, such as when raising children or going to school.

The above is an excerpt from the book A Social Security Owner’s Manual.

Social Security’s PIA – What is this?

peoria il by kla4067If you’ve ever read up on Social Security retirement benefits, you’ve likely come across a number called the Primary Insurance Amount, or PIA. So just what is PIA? That is, besides the airport designation for the General Wayne A. Downing, Peoria (IL) International Airport?

Primary Insurance Amount – PIA

The Primary Insurance Amount (PIA) is the projected amount of Social Security retirement benefits that you will receive if you file for benefits at exactly your Full Retirement Age – FRA, in Social Security Administration parlance.  (see this article for information about determining your FRA).

The PIA is one of the factors used in determining the actual amount of your retirement benefit when you file at other ages – the other factor being the date (or rather your age) when you elect to begin receiving retirement benefits.

So, how is PIA calculated?

In true government style, this calculation can be pretty complicated.  You start off with your Average Indexed Monthly Earnings (AIME – which we defined here). Then, hold onto your hat, because it gets hairy from here:

  • the first $1,024 of your AIME is multiplied by 90%
  • the amount between $1,024 and $6,172 is multiplied by 32%
  • any amount in excess of $6,172 is multiplied by 15%

Note: these are the figures for 2022. The figures used (referred to as “bend points”) are based upon the year when the retiree is first eligible to claim benefits – at age 62.

So let’s work through a couple of examples:

Our first retiree is age 62 in 2022, and is hoping to begin taking Social Security benefits immediately upon eligibility – to get what’s coming to her. Her AIME has been calculated as $6,500. Applying the formula, we get the following:

  • first bend point: $921.60 ($1,024 * 90%)
  • second bend point: $1,647.36 ($6,172 – $1,024 = $5,148 * 32%)
  • excess: $49.20 ($6,500 – $6,172 = $328 * 15%)
  • For a total PIA of: $2,618.16 ($921.60 + $1,647.36 + $49.20), rounded down to $2,618.10

The second example retiree also is age 62 in 2022. His AIME has been calculated as $4,000.  Applying the formula:

  • first bend point: $921.60 (same as before)
  • second bend point: $952.32 ($4,000 – $1,024 = $2,976 * 32%)
  • excess: $0
  • For a total PIA of: $1,873.92 ($921.60 + $953.32), which is rounded down to $1,873.90

You should note that the PIA is always rounded down to the next lower multiple of $0.10.

… And that’s just the start!

Once your PIA is calculated, it doesn’t just sit there like the boring number that it is. Each year, your PIA may be adjusted, according to any additional (increased) earning years you accrue that may impact your AIME. Plus, your Primary Insurance Amount is simply the basis for your Social Security retirement benefit calculation: the age that you begin taking the payment of retirement benefits is taken into the equation as well, which you’ll see in the Retirement Benefit Calculation article.

Social Security Bend Points Explained

bend points

Photo credit: jb

Bend points are the portions of your average income (Average Indexed Monthly Earnings – AIME) in specific dollar amounts that are indexed each year, based upon an obscure table called the Average Wage Index (AWI) Series. They’re called bend points because they represent points on a graph of your AIME graphed by inclusion in calculating the PIA. The points on the graph “bend” as the rate of inclusion changes.

If you’re interested in how Bend Points are used, you can see the article on Primary Insurance Amount, or PIA. Here, however, we’ll go over how Bend Points are calculated each year. To understand this calculation, you need to go back to 1979, the year of the Three Mile Island disaster, the introduction of the compact disc and the Iranian hostage crisis. According to the AWI Series, in 1979 the Social Security Administration placed the AWI figure for 1977 at $9,779.44 – AWI figures are always two years in arrears, so for example, the AWI figure used to determine the 2022 bend points is from 2020.

With the AWI figure for 1977, it was determined that the first bend point for 1979 would be set at $180, and the second bend point at $1,085. I’m not sure how these first figures were calculated – it’s safe to assume that they are part of an indexing formula set forth quite a while ago. At any rate, now that we know these two numbers, we can jump back to 2020’s AWI Series figure, which is $55,628.60. It all becomes a matter of a formula now:

Current year’s AWI Series divided by 1977’s AWI figure, times the bend points for 1979 equals your current year bend points

So here is the math for 2022’s bend points:

$55,628.60 / $9779.44 = 5.6883

5.6883 * $180 = $1,023.89, which is rounded up to $1,024 – the first bend point

5.6883 * $1,085 = $6,171.81, rounded up to $6,172 – the second bend point

And that’s all there is to it.  Hope this helps you understand the bend points a little better.