How Social Security Taxes and 401(k) or IRA Withdrawals Interact

An IRA withdrawal can cost far more in taxes than you think. Here's why.

Questions and answers about Social Security and IRA withdrawals.
It's hard to find easy answers on how taxes on IRA and Social Security work. JamesBrey

Taxes can be complicated in retirement. If you take an extra withdrawal from your IRA one year, your tax rate can skyrocket for the year. It's hard to find answers to how it all works. Here's a question from one reader who was trying to estimate the impact of an IRA withdrawal on their future Social Security benefits.

Question

"Hi Dana,

I have a question about 401(k)/IRA withdrawals and Social Security (SS) taxes.

  I know that any withdrawal is taxed at current rates and that the SS benefits are taxed at 50 or 85% depending on total income levels.

My problem is that my wife and I want to sell our current house, relocate, and buy a new one.  We are both over 62 and both receive SS with total benefits of approximately $30,000. To relocate and buy a new house requires that we withdraw about $60,000 from our IRA and 401(k)s. I've looked at the IRS publications and the SSA website and my confusion is that when they mention taxing the SS benefits they treat it as a decrease in long-term benefits.

Will I just pay the tax on the total income for the year that we withdraw?  Will the SS benefits stay at current amounts for us for future years or are they reduced because our income jumped for one year?

Is there a better way? Thank you in advance for reading this and your reply.

Answer

"Dear relocating,

I think I understand your question.

Let me offer a few clarifications to try to get to an answer. First, yes, IRA withdrawals are taxed at your current income tax rates. However, the taxation of Social Security is not as simple as 50% or 85% of it being subject to taxation. Your "other sources" of income (called combined income or provisional income) go into a formula and the result is anywhere from 0 - 85% of your Social Security benefits can be taxed.

So it could end up that 12% of your benefits are subject to income taxes, or 77%, for example. This is recalculated each year based on your various income sources.

However, this tax is not a decrease in long-term benefits. I think you (or perhaps the info on the SSA website) may be confusing something called the earnings limit with a tax. The earnings limit says if you are collecting Social Security before you reach your Full Retirement Age, and you have too much earned income, then you may owe some of your Social Security benefits back. This earnings limit should not apply in your situation as an additional IRA or 401(k) withdrawal is not considered earned income.

So, as you have described it, you would only pay income tax on the additional withdrawal, which may cause more of your Social Security benefits to be subject to taxation (which means more tax owed) but it would only apply to the calendar year in which this excess withdrawal (and thus extra taxable income) occurred. There would not be a reduction in your Social Security benefits.

Now, on to your question "Is there a better way?" There may be, but it would involve a lot more analysis. For example, could you use a home equity line of credit to come up with a down payment to avoid an extra IRA/401(k)withdrawal?

Could you spread your IRA/401(k) withdrawal over two calendar years? Do you normally take IRA/401(k) withdrawals to meet your income needs? Do you have a mortgage? Will you have a mortgage on your new home? Considering all of this in a way that includes the tax impact takes work - but sometimes it results in substantial savings by finding a way to coordinate your decisions to reduce your expected tax bill throughout retirement.

Hopefully this helps, and as you mentioned you are from Buffalo, NY, are you moving somewhere warmer?