personal exemptions – Retirement Income Center

Parts 3 and 4 of this series addressed the first two of three primary economic benefits associated with a Roth IRA conversion: (1) elimination of taxation on 100% of the growth of Roth IRA conversion assets and (2) elimination of exposure to required minimum distributions, with the first one being the most important and overriding reason in most cases for doing a conversion. This post discusses the third and final benefit – potential reduction in taxation of Social Security benefits.

Economic benefit #3 has intentionally been saved for last. Unlike the first two benefits which will occur provided there is an increase in the value of the Roth IRA after the conversion (benefit #1) and you live until at least age 70-1/2 and you haven’t depleted your traditional IRA (benefit #2), reduction in taxation of Social Security benefits is less certain. This is why this benefit is prefaced by the word, “potential.”

As we know from reading the two-part series, Say Goodbye to Up to 30% of Your Social Security Benefits that was published on January 10, 2011 and January 17, 2011, you can lose up to 30% of your Social Security benefits to federal income tax. Per the series, the amount of benefits subject to tax in a particular year is dependent upon four factors: (1) tax filing status, (2) total amount of Social Security benefits received, (3) adjusted gross income, and (4) tax-exempt income. Generally speaking, factor #3 is the most important one in determining the percentage of benefits that will be lost to federal income tax. The greater your adjusted gross income, or “AGI,” the more likely a larger portion of your Social Security will be eaten up by federal income tax.

Traditional IRA distributions are included in AGI. This includes both voluntary as well as required minimum distributions, or “RMD’s.” Roth IRA distributions, on the other hand, typically aren’t included in AGI since they generally aren’t taxable provided that certain rules are followed regarding the timing of distributions. Assuming that you’ve obeyed the rules, you will reduce your AGI in future years when you would have otherwise taken taxable traditional IRA distributions had you not done your Roth IRA conversion.

While a reduction in AGI doesn’t necessarily translate to a reduction in taxation of Social Security benefits, as illustrated in Exhibit 1 of Part 2 of Say Goodbye to Up to 30% of Your Social Security Benefits, there’s a very good chance that this will happen unless the total of your AGI, tax-exempt income, and 50% of your Social Security benefits exceeds several hundred thousand dollars. Per Part 1 of that series, the loss of 30% of Social Security benefits to taxation won’t occur unless you’re in the top 35% tax bracket. In 2011, the 35% bracket isn’t an issue until taxable income, i.e., AGI less itemized deductions and personal exemptions, exceeds $379,150.

Although reduction in taxation of Social Security benefits won’t occur in every situation, it should nonetheless be included as part of most Roth IRA conversion analyses.

Retirement Income Visions™ began a series of posts on the topic of Social Security on September 27th, focusing on various little-known strategies for maximizing Social Security benefits. In addition to the strategies not receiving a lot of publicity, when they are discussed, income taxation is often overlooked. Given the fact that a large portion of Social Security benefits can be subject to income tax, maximization of after-tax Social Security benefits should be your goal with each strategy.

Prior to 1984, Social Security benefits were nontaxable. Beginning in 1984, up to 50% of Social Security benefits became subject to taxation. The percentage was increased from 50% to up to 85% beginning in 1994. Since 1994, up to 85% of Social Security benefits are taxable, depending upon the total of two individual calculations: (1) 50% of Social Security benefits plus (2) adjusted gross income increased by tax-exempt income. While tax-exempt income generally isn’t taxable, it comes into play when calculating the taxable amount of one’s Social Security benefits. Whenever the total of these two amounts, otherwise referred to as “combined income,” exceeds a specified threshold, a portion of Social Security benefits is taxable.

The amount of the threshold is dependent upon your tax filing status. If your status is single, head of household, or married filing separate, the threshold is $25,000. If, on the other hand, your status is married filing joint, then your threshold is $32,000. The greater the excess of “combined income” over the specified threshold, the greater the amount of taxable Social Security benefits.

The $25,000 and $32,000 thresholds are the floor amounts for calculating taxable Social Security benefits. Up to 50% of Social Security benefits are taxable if your combined income is between $25,000 and $34,000 if you use single, head of household, or married filing separate filing status. The combined income level for married filing joint status for taxation of up to 50% of Social Security benefits is between $32,000 and $44,000. Once the upper limits of these respective thresholds are exceeded, up to 85% of Social Security benefits are taxable.

So, if up to 85% of Social Security benefits are taxable, why is the title of this post, Say Goodbye to Up to 30% of Your Social Security Benefits? As with taxation of all income, the amount of income tax that you pay is dependent upon the amount of your taxable income. Taxable income is calculated by subtracting itemized deductions or the standard deduction and personal exemptions from adjusted gross income. Once you determine your taxable income, income tax rates are applied to specified ranges of taxable income that are dependent upon your tax filing status. Federal income tax rates currently range from a low of 15% to a high of 35%.

Assuming that your situation is such that 85% of your Social Security benefits are taxable and assuming that you’re in the top tax bracket of 35%, then you will lose 29.75% (85% x 35%), or approximately 30%, of your Social Security benefits to federal income tax. Conversely, you will retain 70.25% (100% – 29.75%), or approximately 70%, of your benefits after paying the income tax attributable to them.

In an effort to help you better understand taxation of Social Security benefits, next week’s post will include calculations of taxable Social Security benefits, federal income tax attributable to taxable benefits, and Social Security benefits net of federal income tax for various income levels. All of you analyticals will love this one!