Navigating Retirement: The Cost of Using a 401(k) Bridge to Delay Social Security

As financial advisors, our goal is to help you navigate the complex decisions surrounding retirement, ensuring that your golden years are as prosperous and worry-free as possible. One critical decision many of our clients in their 50s face is when to start taking Social Security benefits. The strategy of using a 401(k) or similar retirement account as a bridge to delay Social Security benefits, while popular, warrants a closer examination. Specifically, let’s explore the financial implications of this strategy, incorporating the impact of taxes, required minimum distributions (RMDs), and Medicare benefits.

The Appeal of Delaying Social Security

The logic behind delaying Social Security benefits is straightforward: for every year you delay claiming Social Security past your full retirement age (FRA) up to age 70, your monthly benefit increases by approximately 8%. At face value, this increase can significantly boost your retirement income. For instance, the maximum Social Security benefit at age 62 is around $2,324 in 2023, while at age 67 (considered the FRA for many), it jumps to approximately $3,345. Delaying benefits seems to promise more financial security in your later years.

The 401(k) Bridge: A Closer Look

Consider you have $2,000,000 in your 401(k) at age 62 and decide to use this as a bridge to delay taking Social Security. While this strategy might initially seem advantageous, several factors complicate the picture:

1. Tax Implications: Withdrawals from your 401(k) are taxed as ordinary income. Assuming a conservative withdrawal rate of 4% annually, you would be withdrawing $80,000 per year, potentially pushing you into a higher tax bracket, especially when combined with other sources of income.

2. Opportunity Cost and Investment Growth: By withdrawing $80,000 annually, you lose out on the potential growth of those funds. Assuming a modest 5% annual return, the opportunity cost of not investing that $80,000 annually over five years is significant, amounting to tens of thousands of dollars in lost investment growth.

3. Required Minimum Distributions (RMDs): Starting at age 73, you are required to take RMDs from your retirement accounts, which could further increase your taxable income. The RMD amount is based on the account balance and your life expectancy, potentially forcing larger withdrawals than needed and pushing you into an even higher tax bracket.

4. Impact on Medicare Premiums: Your income in retirement also affects your Medicare Part B and Part D premiums. Higher income levels can result in increased premiums due to the Income-Related Monthly Adjustment Amount (IRMAA). By increasing your taxable income through 401(k) withdrawals or RMDs, you could face higher healthcare costs.

The Case for Claiming Social Security Early

Given these considerations, claiming Social Security benefits at age 62 might be more advantageous than it appears, especially for those with substantial savings in tax-deferred accounts. Claiming early:

• Reduces the Need for Large 401(k) Withdrawals: By receiving Social Security benefits earlier, you can lower your annual withdrawal rate from your 401(k), preserving more of your savings and potentially reducing your tax liability.

• Mitigates the Impact of RMDs: Smaller 401(k) balances due to earlier, smaller withdrawals could result in lower RMDs, helping manage your taxable income more effectively in your 70s and beyond.

• Protects Against Higher Medicare Premiums: By managing your taxable income more effectively through strategic withdrawals and Social Security benefits, you can potentially avoid higher Medicare premiums linked to higher income levels.

Real Numbers, Real Decisions

For example, let’s say you decide to delay Social Security until age 67 to maximize your benefits. If you withdraw $80,000 annually from your 401(k) starting at age 62, by age 67, you would have withdrawn $400,000 (not accounting for taxes or investment growth). If instead, you started Social Security benefits at 62, even at a reduced rate, you could potentially reduce your annual 401(k) withdrawals by the amount of your Social Security benefit, preserving your 401(k) balance for future growth and reducing your tax liability over time.

Furthermore, considering the impact of RMDs starting at age 73, if your 401(k) balance remains higher due to earlier, larger withdrawals, your RMDs could significantly increase your taxable income, potentially impacting your Medicare premiums as well.

Conclusion

While the strategy of using a 401(k) as a bridge to delay Social Security benefits might seem wise, a closer examination reveals several potential pitfalls, particularly regarding taxes, RMDs, and Medicare premiums. For individuals with substantial retirement savings, the benefits of claiming Social Security at a reduced rate earlier might outweigh the advantages of delaying. As always, personal circumstances vary, and consulting with a financial advisor to examine your specific situation is crucial. Making an informed decision requires a nuanced understanding of the interplay between taxes, investment growth, and benefits, ensuring that your retirement strategy is both sustainable and aligned with your long-term financial goals.