Integrating Roth IRA With Social Security Benefits

From all the information that I’ve been reading recently, it appears that the coming opportunity to convert IRA or qualified retirement plan funds to Roth IRA isn’t really very popular with most folks.  I suppose it’s not really a surprise – the Roth IRA has long been a confusing topic for a lot of folks, and the conversion itself doesn’t make things much clearer. [caption id="attachment_3331" align="alignright" width="300" caption="Integrating Roth IRA with Social Security Benefits"]Integrating Roth IRA with Social Security Benefits[/caption] There are some great benefits to be had from converting funds to a Roth IRA – but that doesn’t mean that everyone within earshot should just willy-nilly go off and convert their IRAs to Roth IRAs.  One factor that many folks likely haven’t thought about is the integration of Social Security benefits with the possibility of a Roth IRA conversion.

Taxation of Social Security

As you may be aware, depending upon your “provisional income”, various amounts of your Social Security benefits may be taxable.  At this time, for example, if your provisional income is more than $25,000 (or $32,000 for a married couple), then 50% of your benefits would be taxed.  Above $34,000 ($44,000 for a married couple), 85% of your Social Security benefit is taxable. Provisional income is made up of – your adjusted gross income (AGI, the amount in the last line on the first page of form 1040) plus tax-exempt interest earned for the year, plus ½ of the amount of your Social Security benefit.  So the trick is to limit your income that makes up AGI, while not overdoing it with tax-exempt interest income.  One way to do this is to generate income from a Roth IRA.

A Tale of Two Taxpayers

Two taxpayers, Stevie and Christine, both age 62 and retired, have vastly different outcomes for their tax costs.  For simplicity’s sake, we’ll say that both women are single, and are collecting identical Social Security benefits of $20,000, and that each has an income requirement of $45,000 each year.  In addition, each of the women has a pension available, which will either pay out a $25,000 payment each year, or is available as a lump sum for rollover at the amount of $500,000.

Stevie

Stevie decides to take the pension payments of $25,000 per year.  Come tax time, she learns that she will have to pay tax on 85% of her Social Security benefit ($17,000) because her provisional income adds up to $35,000, which is above the $34,000 limit.  So the tax on this amount ($25,000 pension plus 85% of SS, or $17,000) is $6,688, or roughly 15% of her total income.  Assuming that nothing changes about the situation, Stevie can count on paying around 15% of her income in tax for the rest of her life.

Christine – Option 1

Christine, on the other hand, takes a look at the numbers and decides that it might make more sense to attack the situation differently… she takes the lump-sum payout from her pension plan and rolls the money over into an IRA.  If Christine were to simply leave things this way and start taking a distribution of $25,000 each year, she would have exactly the same tax treatment that Stevie is getting.  However, if Christine should decide to do a conversion of the IRA to a Roth IRA in 2010, paying tax in 2011 and 2012, she would be paying tax of approximately $70,000 each of those years, leaving her with a net balance in the Roth account of roughly $360,000. Now Christine pays no tax (under current laws) for the rest of her life!  Given that her provisional income can not be more than the limits, her Social Security benefit will never be taxed, and since all of her funds are in the Roth IRA, there is no tax owed at all.  But this is a very high price to pay up front – roughly 1/3 of her IRA account – to make up the difference, Christine would need to take this tax-free income for around 20 years, as long as income tax rates stay the same.  If the income tax rates rise, the break-even time would be less, of course.

Christine – Option 2

But what if Christine instead took her income requirement each year (the same as Stevie), paying the roughly 15% tax, but then took an additional amount from the IRA and converted it to a Roth?  If she converts $50,000 in the first year and pays the tax that year, the additional tax would amount to roughly $12,500.  But here’s the magic:  having done this, Christine can now reduce the amount that she takes from the IRA to just below the $34,000 limit, thereby reducing the amount of her Social Security benefit that is taxed each year to 50%.  The difference, $1,000 each year, could be taken from the Roth IRA at no tax impact.  Now Christine’s annual tax would be reduced to $4,668, a savings of over $2,000 per year in taxes.  This reduces the break-even period to approximately 6 years over Stevie’s situation.

Christine – Option 3

How about another step – what if Christine did the conversion of $50,000 for five years in a row, paying a total of $62,500 in tax.  Now she can reduce the amount that she takes from her IRA each year to an amount that allows for NO tax on her Social Security benefit – and a minimal amount on her IRA distributions, as well – total tax is now $1,668 – a full $5,000 less than the tax that Stevie pays, assuming tax rates remain the same.  As before, rising rates will make this strategy look even better.  The break-even is now approximately 12½ years – but would be less with higher tax rates.

Summary

There’s a lot of math going on in this article… the point was to show how this Roth IRA conversion activity isn’t just a question for the rich.  It can have an impact on folks at all levels of income – and there are many ways to slice the choices.  It can be very costly to do nothing, as well as quite lucrative to do some planning and strategizing on this point.  As always, talk to your financial professional before making any dramatic moves, just to make sure you’ve got it right.  The IRS rarely grants a mulligan. Note – for the purpose of illustration, I used current tax rates throughout the examples.  I know that rates are going up in 2011 and are likely to increase in years ahead – this will only make the illustrations I’ve done here look better for the Roth conversion (in most cases). Photo by: Fabricator of Useless Articles

About the author

Jim Blankenship, CFP®, EA

Jim Blankenship is the founder and principal of Blankenship Financial Planning, Ltd., a financial planning firm providing hourly, as-needed financial planning and advice. A financial services professional for over 25 years, Jim is a CFP professional and has earned the Enrolled Agent designation, a designation that qualifies him as enrolled to practice before the IRS. Jim is also a NAPFA-registered financial advisor, which designates him as a Fee-Only Financial Advisor.

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