Social Security Taxation And Roth Conversion
April 19, 2016
by John Walton, PhD, PE
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The actuarial adjustments that the Social Security (SS) administration uses to calculate benefits beyond full retirement age have not been updated since 1983. In the intervening years lifetimes have increased and real interest rates have decreased. Longer lives and lower interest rates mean that delaying SS benefits until age 70 is increasingly recommended by financial advisers to increase financial security in retirement.
For most clients who have worked more than 35 years, which is the maximum considered in calculating benefits, delaying SS provides substantial increases in benefits, whereas working more years often does not. Additional years of SS-eligible income beyond 35 years only increase benefits to the extent that the wages earned in subsequent years exceed wage-adjusted income from prior years.
Setting up a bond ladder to provide secure income in lieu of SS from the age of retirement until age 70 is the easiest way to fund delaying SS. This requires that assets be spent down at a relatively higher rate prior to receiving the enhanced SS payout (i.e., “buying more Social Security”).
Given the increased SS benefit from delay and the required extra spend down of assets to “purchase the enhanced SS benefit,” SS will be a greater portion of total income. SS will also be a large portion of income for the many Americans who do not have adequate savings.
Prior to age 70.5, when required minimum distributions (RMDs) begin, clients should consider converting all or a portion of their 401K/403B/IRA savings into a Roth IRA. Conversion to a Roth IRA depends primarily on tax rates at the time of rollover relative to rates in the future.
The unique way that SS benefits are taxed dramatically changes the marginal tax on retirement income, particularly for clients with benefits enhanced by delay until age 70. At low levels of total income, SS benefits are tax free, but as income increases, up to 85% of benefits are taxable. Since an additional dollar of outside income can make more SS income taxable, the extra dollar of income requires the payment of tax on the extra dollar, plus tax on the newly taxable portion of SS. At some points in the formula, this turns the 15% tax bracket into (1 + 0.85)*.15 = 27.75% and the 25% tax bracket into 46.25%. This makes conversion to Roth substantially more beneficial, even if the client appears to be in a higher tax bracket today relative to retirement.