Don’t Forget Social Security in Your Roth IRA Conversion Strategy

With the coming change to the Roth IRA conversion rules, there is lots of focus on the decisions you face when considering a conversion.  One area that often gets short shrift is the future impact on Social Security benefits taxation.

Understandably, this hasn’t really hit the radar for next years’ conversion topics, because this is primarily important to folks with a much lower income.  So if you’re one of those fatcats with an annual retirement income projected above $100,000, then you might not want to bother reading any further – this likely doesn’t apply to you. (But look at the note at the bottom before you leave!)

However, (and there’s always a however in life), this will be important to consider if you are in a position to reduce your net non-Social Security plus ½ of your Social Security Benefit to a level below $44,000 (even moreso if you can reduce it to below $32,000).  Those are the numbers for Married Filing Jointly – the figures for Single, Qualifying Widow(er), Head of Household, or Married Filing Separately are  $34,000 and $25,000, respectively.

Now, it may seem like this is a pretty insurmountable position to be in… after all, you need an income of (for example) $60,000 in order to just get by!  Imagine, though, what would happen if you were able to take a large portion of that $60,000 from a tax-free source, such as a Roth IRA.  In that case, you might be able to get by without having to pay tax on any or a large portion of your Social Security benefits.

The Facts

I guess I got a little ahead of myself – let’s back up and look at the facts.  If your net AGI (not including line 20b) plus ½ of your Social Security Benefit is less than $32,000 ($25,000 for Singles, et al), then none of your Social Security Benefit is taxed.  If the amount described above is greater than $32,000 but not more than $44,000 (between $25,000 and $34,000 for Singles), then 50% of your Social Security Benefit will be taxed.  If that same figure is above $44,000 ($34,000 for Singles), then 85% of your Social Security Benefit will be taxed.

Example (*uses 2009 tax tables – your mileage may vary)

Let’s say for example that John and Mary’s lifestyle need requires an income of $60,000, and they have a combined Social Security Benefit of $25,000.  So, John and Mary take a total of $35,000 from their IRAs (total balance of $500,000) to make up the difference.  Running the calculation, when we add ½ of the SS benefit to the rest of the income ($12,500 plus $35,000) we get $47,500.  Since this is greater than $44,000, 85% of the SS benefits are taxed.

If John and Mary decided to convert 20% of their IRAs to Roth IRAs ($100,000), now instead of taking $35,000 from the traditional IRA each year, they could take $28,000 from the traditional IRA and $7,000 from the Roth.  Re-running the calculation, now ½ of SS benefit plus AGI ($12,500 plus $28,000) equals $40,500.  Now, only 50% of the SS benefit is taxed!  Granted, in the year of the Roth conversion, John and Mary had to pay considerably more tax on the conversion amount, an additional $21,980, but this pays off in reduced taxable SS benefit after just over 9 years.

Taking this a step further, if John and Mary decided to convert 40% of their IRAs to Roth IRAs ($200,000), we can eliminate taxation of SS benefits altogether.  Now we’re taking only $21,000 in income from the traditional IRA and $14,000 (tax free) from the Roth.  Running the calculation again, we come up with $33,500 ($12,500 plus $21,000) – now we’re less than the $34,000 limit.  At this level, NONE of the Social Security benefit is taxed.  Again, there is a significant tax cost in the year of conversion ($51,415), which is paid off in reduced taxes in just over 11 years at today’s rates.  With both examples, if future tax rates increase when future tax rates increase, the payoff is even faster.

So you can see how this could be a great strategy for folks that are capable of reducing their income component by such a factor.  There’s also the added benefit of reduced amounts against which Required Minimum Distributions are calculated.  As you reach the RMD age limit (70½), you may have determined that you don’t need the amount that is prescribed as income.  If you’ve reduced the traditional IRA balance by converting a good portion to a Roth IRA, the RMD amount will be less by proportion.

Of course, you could also reduce the tax hit by drawing out the time within which you do the conversions – such as splitting up that $200,000 over four years, for example – this way you’d have much more of the conversion being taxed at lower rates.  Obviously, your situation is going to vary from the example, so work closely with your tax advisor as you make plans.

Note:  Keep in mind that this strategy could work for literally anyone at any income level – as long as the income isn’t from a fixed source, such as a traditional pension.  If it’s from investment accounts, IRAs, annuities, or some qualified retirement plan, then you should consider this strategy to see if it makes sense for you.

Photo #1 by Chika

Photo #2 by Aric Riley

I can learn from you, you can learn from me - please leave your comments and links!

Jim Blankenship, CFP®, EA, is an expert in personal retirement, IRAs, and tax issues, with more than 20 years of experience in the industry.  . Read more from this author