A primer on the IRA "bridge" to bigger Social Security benefits

First, the good tax news. 

Clients approaching retirement can delay their future required minimum distributions — and accompanying income taxes — until they're 73 rather than starting them at 72, as was the rule prior to the Secure 2.0 Act. In 2033, the first RMDs will fall back to 75.

Those changes will help pre-retirees lock in more tax-advantaged investment gains in their individual retirement accounts and build more wealth apart from Social Security.

The bad news is that they face the potential for much higher taxes in the future if they wait that long to begin taking the distributions into their taxable income.

More financial advisors and tax professionals with clients who are eligible for penalty-free IRA withdrawals as young as 59½ years old are considering how the distributions can be a bridge to claiming Social Security benefits later and avoiding so-called stealth expenses, according to four experts who spoke with Financial Planning. The approaching end of the year and the current federal tax brackets mean that it's an especially timely topic of discussion.

The later the clients claim Social Security, the higher their monthly payments will be in retirement. At the same time, those benefits draw taxes for higher-income households that are also subject to higher Medicare costs. If the clients have built up healthy nest eggs in their traditional IRAs, those assets pose a complex planning opportunity with some built-in risks that can make a major impact on their retirement.

Ed Slott and Company

"For a lot of people, their IRA is one of their biggest assets, if not their biggest asset," Sarah Brenner, the director of retirement education with retirement consulting firm Ed Slott and Company, said in an interview. "It makes sense to use this taxable money earlier. It makes sense to use this money as a bridge."

She and the other experts stressed that the bridge depends on any number of factors that are part of the retirement mix. The strategy also represents a departure from "the old regime," which held that advisors and their clients should "defer, delay" and "wait until the bitter end" when they were obligated to receive the IRA distributions, according to Heather Schreiber, the founder of advanced planning consulting firm HLS Retirement Consulting.

"Now we've had to change our logic about that," she said. "We have to think about shifting the mindset of people to say, 'How do we take our assets in a way that's the most tax-efficient?"

READ MORE: 30 tax questions to answer by the end of the year

The essentials

Advisors and their clients will be looking especially closely at four categories of numbers to figure out whether to use the bridge, with their cash flow needs being the first basic question. 

They'll need to know the size of their possible RMD — the quotient of their IRA balance divided by life expectancies issued by the IRS. Then they'll weigh that amount against their Social Security benefit, which is based on their average earnings over as many as 35 years in the workforce and their timing for taking benefits as early as 62, at the full retirement age between 66 and 67, or as late as 70. That's when there will no longer be an advantage to waiting to claim the benefits.

If those considerations weren't enough, they'll need to remember that roughly 40% of Social Security beneficiaries pay federal taxes on the payments they receive and those in some areas must pay state duties on them as well. At the federal level, as much as 85% of the benefits are taxable for individuals with more than $34,000 in "combined income" or joint filers with $44,000. Medicare adds another layer of questions, since any possible Income Related Monthly Adjustment Amounts (IRMAA) with their monthly premiums are tied to income as well.

Each of the permutations could look different through, say, converting the IRA to a Roth to avoid the question of RMDs entirely for the rest of the client's life while also paying the taxes for the switch. A qualified charitable distribution from an IRA could provide another way around the additional income from the mandatory withdrawal.

Carson Group

The stealthiness of the tax and expenses comes from their interaction across income brackets, healthcare costs, RMDs and other areas, according to Erin Wood, a senior vice president for financial planning and advanced solutions with Omaha, Nebraska-based registered investment advisory firm Carson Group.

"All of these things end up being connected together," she said. "It does surprise people if they're in a different position than they thought they would be in."

For some clients, unexpected health problems could put them in that type of bind in which they may need to tap the Social Security benefits right away, according to Valerie Escobar, a senior wealth advisor with Kansas City, Missouri-based advisory practice BMG Advisors. For others, they may wish to keep earning tax-free yield in their IRAs and claim benefits sooner as well, she noted. A third group could opt to use earlier withdrawals as a bridge to wait until 70 for Social Security to get the maximum benefits possible.

Valerie Escobar

"I know that if I can wait as long as possible, then 8% growth is going to be credited to me," Escobar said. "It is a way to offset the risk. You're putting it on the government and not having to make it on your own investment dollars."

READ MORE: The post-'stretch' home stretch for Roth IRA conversions

Timely questions

In general, the last quarter marks a good time for completing any RMDs or other withdrawals or planning them for next year. The new rules under Secure 2.0 lent another reason for a fresh look at a clients' options and mandates, according to Brenner.

"Roths are more important than ever," she said. "They can access that completely tax-free during their retirement."

The expiration date of many provisions of the Tax Cuts and Jobs Act of 2017 at the end of 2025 tacked on more incentive to convert to a Roth or take distributions under brackets that may revert to their previous, higher rates in 2026, Shreiber noted.

"Do you wait or do you take advantage?" she said. "These years — especially this year and next — are really pivotal opportunity years to consider doing that."

The current lower rates may act as a "big, big savings opportunity to take advantage of now," Wood agreed, noting that another shift in IRA guidelines from Secure 2.0 in 2025 and beyond will give clients between the ages of 60 and 63 a chance to make larger so-called catchup contributions to their accounts. Those "can be gold mines for getting extra money saved as well," but advisors and their clients must find the right balance with their future taxes, she said.

"How much income you have in every given year is the difference between being in a higher tax bracket and a lower tax bracket and what level your Social Security is going to be taxed at as well," Wood said.

READ MORE: Planning for 2025's tax brackets and retirement rules

Avoid these mistakes by planning

All of the experts pointed out that clients could get a double whammy from higher taxes and lower benefits by claiming Social Security while still working full- or part-time. The significant hit to benefits offers another rationale for using the bridge strategy to claim later or simply to think through the RMDs far in advance.

"It gives you much more flexibility," Escobar said. "It allows your model to be able to have more options when you're planning it all out for your clients."

Advisors should guide clients through the decision about when to take IRA distributions and claim Social Security by assisting them in avoiding two of the most common mistakes, according to Shreiber. 

The first comes from underestimating how long they'll live in general and in retirement. The second revolves around the possible negative impact of a "widow's penalty" in the form of "substantially lower income" for a surviving spouse when there is a significant disparity between their earnings and ages and the older one took Social Security benefits early, she said.

HLS Retirement Consulting

Talking to clients early and often about the bridge strategy and other tools that may be at their disposal in their retirement can set them up for financial security down the line.

"I tell advisors all over the country that consumers need them — they need them as their advocates on this. They go to Social Security and oftentimes come out more confused than they went," Shreiber said. "They need help. They really need advocates, and they're searching for them. So this is an opportunity for advisors to really help their clients by getting more educated about Social Security."