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

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

Questions and answers about Social Security and IRA withdrawals.
••• 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. 

Complicated but not unusual issue

Any withdrawal from an IRA or 401(k) is taxed at current rates and Social Security benefits are taxed at 50 or 85% depending on total income levels.

A retired couple wants to sell their current house, relocate, and buy a new one.  They are both over 62 and both receive SS with total benefits of approximately $30,000. To relocate and buy a new house requires that they withdraw about $60,000 from their IRA and 401(k)s. They've looked at the IRS publications and the SSA website and are confused because when they (IRS) mention taxing the SS benefits they treat it as a decrease in long-term benefits.

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

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 they (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 this situation as an additional IRA or 401(k) withdrawal is not considered earned income.

So, as described above, they 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 their Social Security benefits.

Now, Is there a better way? There may be, but it would involve a lot more analysis. For example, could they use a home equity line of credit to come up with a down payment to avoid an extra IRA/401(k) withdrawal? Could they spread their IRA/401(k) withdrawal over two calendar years? Do they normally take IRA/401(k) withdrawals to meet their income needs? Do they have a mortgage? Will they have a mortgage on their 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 their decisions to reduce their expected tax bill throughout retirement.