People love finding money.  In fact, as a financial planner, nothing gives me more satisfaction than to find money for them – riches they didn’t know they possessed.  When the conversation lags at a dinner party, one way to get it going again by asking people to relate the answer to answer the question: “What was the largest amount of money you have ever found at one time?”  The answers can be fascinating. Everyone, it seems, has a “found money” story.  Some will tell about scrounging for coins in the family sofa, or the back seat of the family sedan.  Others have found money in old wallets while cleaning out a desk drawer, or $20 bills in wastebaskets.  Personally, the most I have ever found was a $10 bill in an old jacket pocket.  One friend, however, said he found two one-hundred dollar bills on the floor of a hotel restroom.  He said his first inclination was to find the rightful owner.  Then he said he realized how fruitless that search would likely be, so he decided he would pocket the money but use it for a worthy cause.  I was eager to know what the worthy cause turned out to be, but someone else at the party interrupted him to tell their story and the conversation moved along.

Found money is exciting money.  Why?  Because it is a surprise. Regardless of the amount, you just feel lucky the rest of the day.

As a financial planner, I often find money “hiding in plain sight” on forms and documents, disguised as either would-be tax obligations that disappear when certain strategies are employed, or better returns on money that is either unemployed or under employed.  It is quite rewarding to see the smile of recognition form on clients’ faces when they realize they are in possession of an asset that didn’t know they had.

Saving money is the same as finding money.  I love spotting a tax that would have been paid had we not found and pointed out an IRS provision that served to mitigate that perceived obligation. Bing! It’s like spotting that $100 bill on the sidewalk.

Most clients with whom I work tell me they don’t mind paying their fair share of taxes; they just don’t want to pay more than their fair share.  I am especially gratified when I am able to help retired clients find ways to legally and ethically avoid overpaying taxes, because more than any other segment of the population, seniors need their assets.

One of the first places I look when searching for this found money in client’s tax returns is a simple form that is published by the IRS, but is seldom seen.  In fact, when I examine tax returns, I rarely see this form included in the packet.  It is a worksheet, actually, that is not meant to be submitted with your tax returns, but should be kept with the file.  It’s called, appropriately enough, the “Figuring Your Taxable Benefits” worksheet.  It has been my observation that people who do their own taxes often do not know this form exists, and many CPAs are not aware of it, either.  Yet, it is this form that (a) helps you determine how much of your Social Security is taxable according to IRS regulations, and (b) helps you determine if there are ways to legally avoid paying that tax.

Before I go any further, let me pause here and explain something.  Whenever I use the two words “avoid” and “tax” in the same sentence, I can see a few eyebrows arch upward. But there is a big difference between tax avoidance and tax evasion.  What is the difference?  Oh, about 10 to 20 years (bada bump…but seriously folks…).  Please rest assured, dear reader, that there is absolutely nothing improper, illegal, unethical or un-American about taking advantage of the provisions found in the IRS Code that enables us to position our assets in such a way as to eliminate unnecessary taxation.  Keep in mind, that there are 5.6 million words in the IRS code – about seven times as many as the Bible.  If you are looking for chapter and verse on how to reduce your taxes, however, you won’t find a large subheading in the IRS code entitled “How to Reduce Taxes.”    The language is buried among all the other words and phrases.  You have to know what you’re looking for to find it.

You can find this worksheet on the web.  It is publication 915, entitled Social Security and Equivalent Railroad Retirement Benefits, and can be found at http://www.irs.gov/pub/irs-pdf/p915.pdf. Once you locate worksheet one, go to line one.  It will read: “Enter the total amount from box 5 of ALL your Forms SSA – 1099 & RRB 1099.”  That’s essentially the 1099 you get from the government stating how much Social Security income you received that year.  The letters RRB stand for Railroad Retirement Board.  It’s a long story as to why, but it means practically the same thing.  What goes on that line is the total you received.

Line two tells you to divide that number in half and enter it in the blank provided. Then you are asked to add that figure (the one on line two) to all of your other income and move it over to the blank provided at the end of line three. That is going to be the amount you will pay taxes on.  Notice that all other forms of income are listed dollar-for-dollar.  But when it comes to your social security, the formula calls for only half of the total amount you received when figuring up your tax liability. In IRS speak; this is called the combined income formula.

Why is this form and this formula so important?  Let me share with you the findings reported in Recalibrating Retirement Spending and Saving by John Ameriks and Olivia S. Mitchell.  In chapter seven of the above mentioned book there appears a very detail discussion entitled “Rethinking Social Security Claiming in a 401(k) world.  This piece of research was completed in August, 2007 by James I. Mhaney and Peter C. Carlson for the Wharton School, University of Pennsylvania, one of the most prestigious business schools in America.  Here’s an excerpt:

“The Combined Income formula includes all of a retiree’s income excluding Roth income together with 50 percent of their Social Security income. The amount of Social Security that is taxable is the minimum of three tests: 50 percent of the Combined Income amount over the first threshold plus 35 percent of Combined Income over the 2nd threshold, or 50 percent of benefits plus 85 percent of Combined Income over the 2nd threshold, or 85 percent of benefits. Combined Income counts all of the income that is normally taxable plus tax-free municipal bond income. Therefore a married couple which has saved diligently within a 401(k) can face a very high marginal tax rate on an additional dollar of IRA income. If the spouses are in a 25 percent tax bracket, they may pay 25 cents on the IRA dollar as ordinary income tax and another 21.25 cents on the Social Security dollar now subject to taxation at 85 percent ($1 x .85 x 25 percent). The effective marginal tax rate on that dollar is therefore 46.25 percent.

“State taxes can push the marginal tax rate even higher. Some financial journalists have dubbed this concept the “tax torpedo”. But just as the tax torpedo can accelerate the taxes due on a retirement income strategy, trading IRA income for Social Security income can create a reverse tax torpedo and drastically reduce taxes.”

Did you catch that?  Trading IRA income for Social Security income can create a reverse tax torpedo…that will drastically reduce your taxes in retirement.  Don’t forget that earlier statistic: 46.1% of all people die while depended solely on Social Security income.  The report continues:

“Many of these retirees will find themselves hit by the tax torpedo. Contrast, however, an individual who delays taking Social Security and funds his needs out of his IRA or other qualified plan is, in essence, trading IRA income for higher Social Security income. This can provide distinct and measurable tax advantages. In lieu of just assuming that 85 percent of Social Security income will become taxable, it is important to recognize what type of income is being received. Since Social Security income only counts at a 50 percent rate into the Combined Income formula, much larger amounts of Social Security can be received before the Combined Income thresholds are met. Therefore, when trading an IRA dollar of income for a Social Security dollar, not only is the IRA dollar no longer present (and thus no tax is due), but less Social Security income is also subject to taxation.

“A quick illustration is as follows: assume an IRA dollar is removed from the income pool and is added back in the form of Social Security. Removing the IRA dollar causes the Adjusted Gross Income to reduce by one dollar. Adjusted Gross Income (AGI) is income including wages, interest, capital gains, and income from retirement accounts adjusted downward by specific deductions (including contributions to deductible retirement accounts); but not including standard and itemized deductions. The IRA dollar being removed also causes Combined Income to drop by a dollar. The Social Security dollar that is added back counts only half to Combined Income, netting a 50 cent decrease in the Combined Income amount. If, for example, we assume that the Combined Income amount is already over the 2nd threshold, that 50 cent decrease results in an additional 42.5 cent reduction to Adjusted Gross Income (AGI). This results in a total AGI reduction of $1.425. The total gross income has not changed, but AGI is reduced by $1.425. In a 25 percent bracket, this saves $0.35625 in federal taxes on that dollar of income. If the beneficiary’s state of residence also taxes Social Security, it functions the exact same way, albeit just with different tax rates. If the state does not tax Social Security, the lower IRA income still reduces state taxes. Of course, when enough dollars are shifted to Social Security (from an IRA), the retiree may slide into a marginal tax bracket lower than 25 percent. Therefore, additional retirement income such as Required Minimum Distribution amounts may also benefit from lower tax rates. Of course, additional income could be subject to the “tax torpedo” as well.

An example with $69,000 of pre-tax income for a retired married couple both ages 72, having Social Security income of $24,000 plus IRA income of $45,000 results in Adjusted Gross Income of $62,050. Conversely, the couple who delays Social Security and has Social Security income of $39,000 with a lower IRA income of $30,000 has the same pre-tax income of $69,000 but an adjusted gross income of only $40,675. The first couple has $21,375 more in Adjusted Gross Income — 52.5 percent higher and spends $3,206.25 more in federal income taxes.

Over a lifetime, folks, that can amount to hundreds of thousands of dollars. We actually had an accountant come in and crunch the numbers on sample tax returns just to check out these findings and see how they hold up in real-life situations.  It all checks out.  We even did some “what-if” returns.  One couple had $97,000 in income and they took their Social Security early.  By the time they were age 70 they were receiving around $40,000 in total Social Security income between the two of them.  They also had $57,000 they were taking out of their IRA and other investments.  Based on the Combined Income Formula on the Social Security worksheet, $34,000 of their $40,000 in Social Security benefits would be taxable. Under that scenario, their Adjusted Gross Income (AGI) would be $91,000 and their tax liability would be $9,681.

But what would have happened if they had delayed taking their social security until age 70.  They would have received $80,000 in Social Security benefits as a couple.  They are taking $17,000 from their IRA investments.  Under this scenario, of the $80,000, only $17,850 is taxable.  They doubled their Social Security and halved the taxable portion of it.  Now, their AGI is $34,050 instead of $91,000.  Their taxes owed amount to $1,278 instead of $9,681 – that’s $8,403 lower taxes. The result of this “what-if” return was simply this: Same exact income; lower taxes.

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