Case Study: The Impact of Roth Conversions on a Retiree taking Social Security
Susan’s Client Profile
Susan is a 68-year-old woman enjoying a comfortable retirement supported by $3,000 monthly Social Security benefits, $1,000 in pension income, and approximately $20,000 annually in qualified dividends and long-term capital gains. Her financial goals include maximizing tax-free income in retirement and preserving wealth for future generations. Susan has the following investment accounts to support her. Her required minimum distributions on her IRA will not begin until she is 73 years old. Susan currently only withdraws from her brokerage account for additional income and incurs the above listed long term capital gains.
Account Type |
Account Balance |
Traditional IRA |
$1,000,000 |
Roth IRA |
$100,000 |
Brokerage |
$400,000 |
The Roth Conversion Conundrum
Based on Susan’s income sources, she would normally owe roughly $2,300 in Federal Income tax. Due to Susan having a larger pre tax retirement account balance, she will experience a significant increase in taxable income once she is required to take distributions from her IRA. In theory, we felt the next few years would be a good opportunity to try Roth Conversions. If successful, we could increase her tax free retirement balances and reduce her required distributions in her 70’s.
To achieve these goals, we tested various amounts of Roth conversions using our financial planning software, RightCapital. However, a surprising pattern emerged. Regardless of the conversion amount – whether $10,000, $50,000, $100,000, or even $150,000 – the effective tax rate on the additional income consistently hovered around 26-30%.
This unexpected outcome is primarily attributed to the interaction between Roth conversions and Social Security taxation. As the client’s taxable income increases due to the conversion, a larger portion of her Social Security benefits becomes subject to federal income tax. This phenomenon effectively amplifies the overall tax burden, resulting in the observed high effective tax rate.
Say that again?
The taxation of Social Security benefits can significantly impact a retiree’s overall tax burden. This complexity is often overlooked, but it’s crucial to understand how it can affect financial planning.
The Basics
- Not all Social Security benefits are taxable: If your income is below certain thresholds, you may not owe any federal income tax on your Social Security benefits.
- Income levels determine taxability: The percentage of Social Security benefits subject to tax depends on your combined income, which includes adjusted gross income (AGI), tax-exempt interest income, and half of your Social Security benefits. Meaning, the more ‘other’ income you have, the more your Social Security will be taxed.
- Tax brackets: There are two income brackets where Social Security benefits become taxable:
- Lower bracket: If your combined income falls between specific thresholds (e.g., $25,000 to $34,000 for singles, $32,000 to $44,000 for married couples filing jointly), up to 50% of your Social Security benefits may be taxable.
- Higher bracket: If your combined income exceeds the higher threshold, up to 85% of your benefits may be taxable.
The Impact of Roth Conversions
When a retiree undergoes Roth conversions, their taxable income increases. This increase directly affects the calculation of their total combined income. As a result:
- Increased taxable Social Security benefits: The higher combined income pushes the retiree into a higher tax bracket for Social Security benefits. Consequently, a larger portion of their benefits becomes subject to income tax.
- Amplified tax burden: The combination of taxes on the Roth conversion and the increased taxes on Social Security benefits creates a magnified overall tax impact.
Our Example
In Susan’s circumstance, even a $10,000 Roth conversion was triggering an additional $9,000 in Social Security income to become taxable. You are only converting $10,000, but the total impact is $19,000 in additional taxable income. This creates a nearly 30% tax on the additional income as her projected Federal tax liability jumps from $2,300 to $5,500.
Strategic Pause on Roth Conversions
Based on our analysis, we’ve determined that proceeding with additional Roth conversions at this time is not advisable. Several factors contribute to this decision:
- High Effective Tax Rate: The consistently high effective tax rate on Roth conversions significantly diminishes their attractiveness.
- Tax Code Stability: The current tax code, including provisions beneficial to high-income taxpayers, is expected to remain in place for the foreseeable future. This reduces the urgency to convert traditional IRAs to Roth IRAs to lock in lower tax rates.
- Reasonable Effective Tax Rate Post-RMDs: When required minimum distributions (RMDs) commence, the client’s overall tax rate is projected to be lower than the current effective tax rate on Roth conversions.
- Susan in particular will take advantage of Qualified Charitable Distributions to reduce the tax impact of her RMD.
Medicare Premium Considerations
Another critical factor is the impact of Roth conversions on Medicare premiums. To qualify for the lowest premium tier, a taxpayer’s modified adjusted gross income (MAGI) must remain below $103,000. Exceeding this threshold would result in higher monthly premiums, further eroding the potential benefits of the Roth conversion.
Conclusion
While Roth conversions can be a valuable tool for tax planning, it’s essential to carefully consider the specific circumstances of each individual. In this case, the interplay of Social Security taxation and Medicare premiums rendered Roth conversions less advantageous than anticipated. By maintaining a proactive approach and regularly reevaluating the situation, we can ensure the client’s financial goals are met effectively.