VeriPlan’s Roth conversion analysis features automatically project increased U.S. federal and state income taxes on Social Security retirement benefits
Roth conversions done when one is already receiving Social Security retirement benefits can increase the amount of Social Security retirement benefits that are subject to federal income taxation. For details on federal income taxation of Social Security retirement benefits, see the Social Security section of the Taxes worksheet within VeriPlan.
The 50% and 85% tax brackets for federal Social Security retirement benefits were enacted into law in 1983 and 1993, respectively. Since these brackets were not indexed for inflation, over the years increasing percentages of senior citizens have been paying federal income tax on some or all of their Social Security benefits.
Fewer that 10 of the 50 US states followed the federal model by taxing Social Security. You can learn more about each state in the “How the 50 states and DC tax Social Security and traditional retirement withdrawals” section of VeriPlan’s Retirement Planning worksheet.
For many retirees, their Social Security retirement benefits are not high enough and they do not have sufficient “other” adjusted gross income for any of their Social Security retirement benefits to be subject to federal income taxation. However, increased “other” adjusted gross income will act to push Social Security payments into higher levels that are potentially subject to income taxation. Retirees who have enough other adjusted gross income and can find that their Social Security retirement payments would be divided into three bands:
A) some Social Security payments that are not included in adjusted gross income,
B) some Social Security payments that are 50% included in adjusted gross income, and
C) some Social Security payments that are 85% included in adjusted gross income.
These A, B, and C levels are calculated, and 50% of Social Security retirement benefit income in the “B level” and 85% of Social Security retirement benefit income in the “C level” will be added to overall adjusted gross income. Next, adjusted gross income is reduced by deductions to derive taxable income. Then, taxable income is subject to federal graduated income tax rates and brackets. Because these federal income tax calculations related to Social Security retirement benefits are done on gross income prior to any deductions, your income deductions do not reduce or prevent the potential taxation of your Social Security retirement benefits.
When someone already has the “A-B-C” retirement Social Security benefit and other income situation above, what happens when their “other” adjusted gross income increases? Choosing to do a Roth conversion is one such example of voluntarily increasing one’s adjusted gross income.
To demonstrate how federal income taxation of Social Security retirement benefits operates in conjunction with optional Roth conversions, I will use an example of incrementing by $10,000 the amount of a Roth conversion. Once you have enough other income in retirement for some of your married Social Security retirement benefits to be taxable at the 85% level, here is what happens.
First, the $10,000 Roth conversion increases both adjusted gross income and taxable income by $10,000. Let’s say this tax payer is still in the 12% federal income tax bracket, so the federal Roth conversion taxes due would be $1,200. But that is not the whole taxation picture. Because before this $10,000 Roth conversion was done, this taxpayer already had some of their retirement benefits subject to 85% bracket, this means that 85% of this additional $10,000 of gross income would also be subject to federal income taxes. Assuming that the taxpayer was still in the 12% federal income tax bracket, then the added income tax would be 85% of the $10,000 times 85% times 12% equals $1,020.
Combined, federal income taxes on this $10,000 Roth conversion with the added 85% of Social Security retirement benefits subject to taxation would be $1,200 plus $1,020 equaling $2,220. Even though the applicable federal income tax bracket is 12%, the effective federal income tax rate would be 22% on this $10,000 incremental Roth conversion.
Clearly, one lesson is to do Roth conversions in the early years of retirement before Social Security retirement benefits begin, whenever possible. Delaying receipt of Social Security after Full Retirement Age up to age 70 will earn delayed retirement credits. Thus, delaying the receipt of Social Security retirement benefits can be an important tactic in reducing the income tax cost of Roth conversions and significantly reducing the investment breakeven age when taxes on Roth conversions would be recovered.
This Roth conversion example could be incremented repeatedly by $10,000 and the tax impacts could be calculated. Once 85% of all Social Security are already subject to taxation, then this added Social Security adjusted gross income factor would drops out. Then, it would seem that you would be back to a federal 12% income tax rate on the next incremental $10,000 converted. However, this may not be the case.
Depending on the level of Social Security retirement benefits and other adjusted gross income factors, once you get over this Social Security retirement benefits ” “almost double” (185%) taxable income hump,” you often find that you have enough taxable income to have been pushed up into the 22% federal tax bracket anyway. Increased Social Security retirement benefits taxation creates a significantly higher hurdle to eventually breaking even on the initial federal income taxes paid on Roth conversions.
Automated Roth conversion analysis features in VeriPlan related to retirement benefits, IRMAA, and Affordable Care Act premium tax credits
As detailed above, the U.S. federal income tax system is a graduated income tax system wherein tax rates increase with higher income. However, there is some “non-linearity” caused by certain other tax rules such as the taxation of Social Security retirement benefits. When you are receiving Social Security retirement benefits, other taxable family income can increase the proportion of your Social Security that is subject to income taxation. VeriPlan projects these taxes automatically.
The Social Security section of the yellow-tabbed Taxes worksheet summarizes the tax rules related to Social Security retirement benefits. Taxable Roth conversion amounts can simultaneously increase the amount of your Social Security retirement income that is subject to income taxation. The graduated income formula for federal taxation of retirement benefits is complex, but VeriPlan calculates this automatically in your projections.
However, you may not be aware that your planned Roth conversion amount in any given year would also increase taxes on your Social Security retirement income, as well. To understand when this would happen follow this procedure, when you are using the Roth Conversion planning table in Section 4 of VeriPlan’s Roth Analysis worksheet. In any projection year that you plan to do some level of Roth conversion by making an entry in Column D, first note the amount of Social Security retirement benefits that would be subject to income taxes in Column N. Then, after you have made your entry into column D, recheck column N to see whether the amount Social Security retirement benefits subject to taxation has increased. This will tell you when you are in the Social Security “double” tax situation discussed above. This is “for your information.” VeriPlan projections will automatically take all of this into consideration when your evalute your future breakeven age on the recovery of all costs related to your planned Roth conversion.
VeriPlan also automatically projects any “Income-Related Monthly Adjustment Amounts” (IRMAA) related to Medicare Part B and Part D monthly premiums. For VeriPlan to project IRMAA premiums for you, FIRST YOU MUST TURN ON VeriPlan’s Medicare and retirement healthcare cost features on the Medicare+ACA worksheet and choose your assumptions and/or accept the defaults provided.
IRMAA is a reduction in Medicare’s subsidy of insurance premiums related to family income. For more information see the IRMAA section of the yellow-tabbed Retirement worksheet. While not a direct income tax, IRMAA functions like an increased income tax for higher income senior citizens.
Column N in the Roth Conversion planning table in Section 4 of VeriPlan’s Roth Analysis worksheet shows whether your projected income after age 65 would be high enough for you to be subject to IRMAA surcharges and at what level. Using a method similar to Social Security retirement benefits in the previous paragraphs, check the IRMAA amounts before and after making a Roth conversion entry in Column D above. Note that there is a one year lag in the affect of IRMAA, so check the adjacent rows.
You should also be aware that future RMDs are considered income for IRMAA, and Roth conversions done in low income years can reduce future IRMAA surcharges. You can demonstrate this by entering Roth conversions in low income years, which would reduce future assets in traditional tax-advantaged retirement accounts. This would reduce RMDs and could lower future IRMAA costs.
Prior to Medicare, those with low income who purchase health insurance through the Affordable Care Act (ACA) system may receive substantial tax credits to lower their insurance premiums. Since Roth conversions are taxable, this increases taxable income and reduces ACA subsidies. For persons in this situation, it might be appropriate to avoid Roth conversions in years prior to age 65. ACA premium subsidies are a tax credit and can be quite substantial. The calculations are complex and can vary by family size, income level, and state. Again, VeriPlan handles these projection calculations automatically. For more on this topic, see Section 4 of the yellow-tabbed Medicare+ACA worksheet and Section 3 of the red-tabbed Optimizations worksheet.
