Retirement Investors: Roth IRA Tax Facts You're Missing

There's been lots of focus this year on the decisions you face when considering a Roth conversion. One area that gets short shrift is the future impact on Social Security benefits taxation.


This is important to consider, especially if you can reduce your non-Social Security income significantly by drawing your income requirement from a Roth account instead of a taxable account.

It may seem like this is an insurmountable position to be in. After all, you may need an income of $60,000 just to 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 — your Roth IRA. In that case, you might be able to get by without having to pay tax on your Social Security benefits (or a portion of them).

The Facts: Let's back up and look at the facts. If your net adjusted gross income (not including Form 1040 line 20b) plus half of your Social Security benefit is less than $32,000 — or $25,000 for singles and heads of household -- 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 — or between $25,000 and $34,000 for singles — only 50% of your Social Security Benefit will be taxed. If that same figure is above $44,000 — or $34,000 for singles — then 85% of your Social Security benefit will be taxed.

Example: Let's say John and Mary's lifestyle requires an income of $60,000 and they have a combined Social Security benefit of $25,000. If they take a total of $35,000 from their IRAs, which has a total balance of $500,000, to make up the difference, adding half of the benefit to the rest of the income (that's $12,500 plus $35,000), gets $47,500. Since this is greater than $44,000, that means 85% of the benefits are taxed.

If John and Mary decided to convert 20%, or $100,000, of their IRAs to Roth IRAs 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, half of benefits plus adjusted gross income — $12,500 plus $28,000 — equals $40,500.

Now only half the benefit is taxed! Granted, in the year of the Roth conversion, John and Mary had to pay considerably more tax on the conversion amount, but this pays off in reduced taxable Social Security benefits.

Taking this a step further, if John and Mary decided to convert 40% of their IRAs to Roth IRAs, or $200,000, they can eliminate taxation of the benefits altogether. Now it's only $21,000 in income from the traditional IRA and $14,000 (tax free) from the Roth. Running the calculation again, it comes up as $33,500 — or $12,500 plus $21,000 — and now is 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, which is paid off in reduced taxes. With both examples, when future tax rates increase, the payoff will occur even faster.

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