Lots of folks are considering doing Roth conversions lately, as the tax climate (and the market) is favorable for converting. However, if you’re receiving Social Security during the year that you do a Roth conversion, it pays to understand the tax implications of adding more income.
Deb had come to my office last year to discuss just such a situation. Deb is already receiving Social Security, but not yet at RMD age (required minimum distribution, age 72 for most). She wants to limit the required distributions from her IRAs later in her life. Plus, the potential for leaving a legacy is compelling to Deb, and a Roth IRA sounded like a good option for her.
Deb is divorced and has a very low requirement for current living expenses. Her home is paid off, the real estate taxes, insurance and utilities are very reasonable, and her vehicle is relatively new. In fact, Deb gets along quite nicely with her Social Security benefit and a small inherited IRA distribution. Within the coming few years (likely near her age 72) Deb will also take a distribution from a small pension and roll this over into her IRA.
All of the remainder of Deb’s assets are non-deferred (not in IRAs or other deferred accounts), in either brokerage accounts or banking accounts and CDs. During her working career, with the exception of the small pension mentioned above, none of her employers made retirement savings plans available to her.
Regarding Deb’s income, she is receiving roughly $18,000 in Social Security benefits, and the inherited IRA generates a required distribution of approximately $4,200 a year. Other taxable items include interest and dividends, totaling approximately $3,600 annually. So her total income is roughly $25,800.
If we consider only the above income items, Deb is squarely within the 0% income tax bracket for 2021 (this engagement occurred last year, of course the brackets are slightly adjusted for 2022), and there is approximately $6,400 before she would have any income tax at all. So for starters, she absolutely should convert at least $6,400 from her IRA to a Roth IRA, as there is no tax cost at all for doing this. Adding this amount of income would have no impact on the taxation of her Social Security, either.
The next threshold that we looked at is the concept of keeping her Social Security in the “untaxed” category. If she converted an additional $1,600 to Roth (for a total of $8,000) her Social Security would continue to be tax-free. The tax cost of this additional step is estimated at $158, or 1.975% of the amount converted.
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Any conversion above that amount begins to impact the taxation of Social Security benefits for Deb. Since Social Security is gradually taxed as your other income increases, we first considered the 50% income inclusion level. As all other income increases, her Social Security benefit begins to be taxable, so the numbers aren’t as straightforward at this point. Adding another $5,500 (for a total Roth conversion of $13,500) brings Deb up to the top of the 10% income tax bracket. At this point, roughly $2,657 of her Social Security is taxed within that same 10% tax bracket. The total tax cost for her conversion of $13,500 is estimated as $974, or 7.2% of the conversion.
When you have other income besides Social Security, the taxation of Social Security works like this: when you add 50% of your Social Security to all of your other income (known in tax preparation parlance as your “provisional income”), if the result is greater than $25,000 ($32,000 for married filing jointly), then a portion of your Social Security benefit will be included as taxable income. If your provisional income is less than $34,000 ($44,000 for MFJ), then only up to 50% of your Social Security benefit will be included as taxable (although it generally works out to be quite a bit less). Once you get to the upper threshold ($34,000 for single, $44,000 for MFJ), your Social Security benefit begins to be included partially at a rate of 85%. As your other income increases, so does the amount of Social Security included as taxable, until a full 85% of your benefit is taxed.
Knowing this, we next looked at how much Deb could convert to Roth before her Social Security started into the 85% inclusion rate. Converting an additional $3,600, for a total conversion of $17,100, exhausts the 50% inclusion bracket. Above this (approximate) amount, Deb’s Social Security begins to be included at the 85% rate. The total tax cost for the $17,100 Roth conversion is estimated as $1,618 (9.46% of the conversion), as she is now in the 12% tax bracket. At this point approximately $4,465 of Deb’s Social Security is included as taxable income. (Note: In our review we used rounded numbers for the most part rather than using up every possible dollar in the various brackets, in order to provide a bit of headroom to be conservative with our calculations.)
To round out the picture, we then looked at the remainder of the 12% tax bracket. Converting an additional $14,500 (for a total of $31,600 converted) would bring Deb to the top of that bracket. Her Social Security benefit (after this conversion) would be included at the full 85% taxable rate, and the overall cost of the conversion would be $4,655, 14.73% of the converted amount.
It should be noted that we’re attributing the income tax cost directly to the converted amount when we are calculating the “cost of conversion,” because this income tax cost wouldn’t have existed without the Roth conversion. Properly, a portion of the tax cost is attributed to all items of her income, but for the purpose of this decision-making process, the tax cost is allocated to the converted amounts.
In the end, Deb decided to convert $13,500, keeping her tax rate within the 10% tax bracket threshold. This fits well with her plan and she has the money available in other accounts to pay the income tax.
If she continues this conversion strategy in a similar manner for a few years, she’ll gradually reduce (or perhaps eliminate) her IRA balance so that she’ll have a smaller (or no) RMD later on in her life. At the same time, she’ll have an increased amount in her Roth IRA, which she can either leave in the account and pass along to her heirs, or withdraw at any time with no tax consequences. The end result is that her Social Security benefit, which covers her primary income needs, will be very tax efficient in the future, possibly even untaxed completely (after the conversions).
Have questions about Social Security? Write us at HelpMeRetire@marketwatch.com.