optimizing Roth conversion when taking SS

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RustyShackleford
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optimizing Roth conversion when taking SS

Post by RustyShackleford »

Until now, retired but not yet taking Social Security, optimizing my Roth conversions was simple: just aim to convert enough so that my taxable income hits the top of the 12% marginal federal tax bracket, as closely as possible.

However, my wife made a unilateral decision to start her Social Security (in Jan 2021), so I figured why not take spousal benefits for the two years between now and when I take my own age70 benefit ? The result is that we have a combined Social Security income (on an MFJ filing) of about $50,000. So I've been running the numbers on what amount of that is taxable, based on various amounts of non-SS income, and thus what total taxable income is.

If I take the earlier strategy of exactly filling the 12% bracket, I come up with a number of about $67,000 in non-SS income. With standard deduction (for both over age 65, of course, and the $600 CARES charitable allowance), that yields a taxable income of about $81,000. Simple enough.

However, if I look at total taxable income versus non-SS income (assuming our total SS income of $50,000), I get a different picture.

non-SS taxable SS total taxable
$35,000 $19,345 $25,845
$40,000 $23,595 $35,095
$45,000 $28,100 $44,600
$50,000 $32,350 $53,850
$55,000 $36,600 $63,100
$60,000 $40,850 $72,350
$65,000 $42,500 $79,000
$70,000 $42,500 $84,000
$80,000 $42,500 $94,000
$90,000 $42,500 $104,000
$100,000 $42,500 $114,000

Note that for amounts of non-SS income much below that $67K figure (that gives a total taxable income at the top of the 12% bracket), that as non-SS income increases by $5000 we see total taxable income increase by nearly double that, $9000 or so. This means that even though total taxable income is below the top of the 12% bracket, the actual marginal tax rate that one is seeing (that is, the add'l tax one pays as non-SS income goes up by a certain amount) is north of 20%. And I'm not sure I want to be doing Roth conversions at that tax rate.

So I'm curious is this analysis looks right, and if so, how others in similar situations decide what to do (that is, how much add'l non-SS income to generate doing Roth conversions, and possibly LTCG harvesting).
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Mlm
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Re: optimizing Roth conversion when taking SS

Post by Mlm »

I think you need to compare the actual rate you pay on the conversion (20%) to the actual rate you would pay at 70 and 72 when RMD's kick in. In my case I can pay 22% now (still in the 12% bracket) or 46.5% later (in the 22% bracket). Are you likely to hit this type of tax torpedo?
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cas
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Re: optimizing Roth conversion when taking SS

Post by cas »

You will probably be interested in the "heat map" from the Boglehead's wiki page on "Taxation of Social Security Benefits".

Look along the bottom axis for your amount of SS income ($50,000). Then let your eye travel upwards in that column (which represents your marginal tax rate as other (ordinary) income is increased. (Marginal tax rates are a bit different if the other income is qualified dividends or long term capital gains.)

For $50,000 in SS benefits (MFJ), you can see that almost all of the nominal 12% bracket has been taken over by the 22.2% part of the "social security tax hump".

(In that range, every new dollar of new ordinary income is taxed at 12%. But it also causes another $0.85 of social security to phase in to being taxable (also at 12%). ($1 + $0.85)*12% = 22.2% marginal rate)

Looking again at the heat map, note that once you start taking your own SS benefit, I'm guessing you will have the possibility of encountering the 40.7% marginal rate zone of the SS tax hump. (This is when your Taxable Income reaches the 22% bracket before the maximum 85% of SS has completely phased in to being taxed. ($1 + $0.85)*22% = 40.7% marginal rate

Since you mentioned tax gain harvesting ... The marginal rate of the SS tax hump can reach 49.95% if you also have qualified dividends or long term capital gains in the mix.

Here is an example of a recent thread where someone was trying to decide on whether to do Roth conversions and encountered the 40.7% and 49.95% rates: viewtopic.php?f=2&t=335251
(Keep reading past the early responses, which didn't consider SS effects and advised to convert to the top of the 12% bracket.
Escapevelocity
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Re: optimizing Roth conversion when taking SS

Post by Escapevelocity »

Are there any software programs where you can put in your future earned income streams as well as FRA expected SS benefit, intended claiming age, current age and account balances in tax deferred IRA/401k and it will optimize your Roth conversion strategy based on ending account balance? I know that Bigfoot's model allows for running multiple scenarios on this, but it doesn't actually run a solve to the best of my knowledge so the user is left to try endless what-if scenarios to see what is best.
RetiredAL
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Re: optimizing Roth conversion when taking SS

Post by RetiredAL »

RustyShackleford wrote: Mon Feb 15, 2021 1:14 pm Until now, retired but not yet taking Social Security, optimizing my Roth conversions was simple: just aim to convert enough so that my taxable income hits the top of the 12% marginal federal tax bracket, as closely as possible.

However, my wife made a unilateral decision to start her Social Security (in Jan 2021), so I figured why not take spousal benefits for the two years between now and when I take my own age70 benefit ? The result is that we have a combined Social Security income (on an MFJ filing) of about $50,000. So I've been running the numbers on what amount of that is taxable, based on various amounts of non-SS income, and thus what total taxable income is.

Welcome to the arcane SS Taxation Rules. Due to SS of 50K, your 22% tax rate starts much sooner than when a regular earner gets to 22%. I'm in the same pickle and chose to convert a modest amount each year.

The first thing to understand is this SS tax law was set 35 years ago, without any inflation adjustment, when only the UBER Rich were caught up in these step catch-up tax calcs. If it had been adjusted for inflation, the $44K upper tax break point would be around $90K in today's dollars and you would not feel so squeezed.

As others have posted, you now need to look at how you will be taxable when your RMD's start. Additionally, understand how will the survivor will be taxed when that happens. I used TaxAct's calculator to do mine, but TurboTax's Estimator and 1040Excel work well too.

If one of you needs long term care, that care is a deductible medical express that can reduced the tax load when the withdrawal is from an IRA. Thus you don't want to convert all your Traditional into a Roth.

Also consider where and how your estate's IRA's ( Roth and Traditional ) remaining will be distributed. If it goes to a child who is already in the 22% bracket, a Traditional will get taxed very heavy across a 5 years withdrawal period, whereas a Roth will not add income on top of your child's. If the remainder is going to charity, they pay no tax on the IRA distribution, so you don't want to pre-pay taxes that the charity will avoid.

Lastly, there is no "perfect solution", just degrees of better or worse.
sidneyinplanning
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Re: optimizing Roth conversion when taking SS

Post by sidneyinplanning »

RustyShackleford wrote: Mon Feb 15, 2021 1:14 pm Until now, retired but not yet taking Social Security, optimizing my Roth conversions was simple: just aim to convert enough so that my taxable income hits the top of the 12% marginal federal tax bracket, as closely as possible.

However, my wife made a unilateral decision to start her Social Security (in Jan 2021), so I figured why not take spousal benefits for the two years between now and when I take my own age70 benefit ? The result is that we have a combined Social Security income (on an MFJ filing) of about $50,000. So I've been running the numbers on what amount of that is taxable, based on various amounts of non-SS income, and thus what total taxable income is.

If I take the earlier strategy of exactly filling the 12% bracket, I come up with a number of about $67,000 in non-SS income. With standard deduction (for both over age 65, of course, and the $600 CARES charitable allowance), that yields a taxable income of about $81,000. Simple enough.

However, if I look at total taxable income versus non-SS income (assuming our total SS income of $50,000), I get a different picture.

non-SS taxable SS total taxable
$35,000 $19,345 $25,845
$40,000 $23,595 $35,095
$45,000 $28,100 $44,600
$50,000 $32,350 $53,850
$55,000 $36,600 $63,100
$60,000 $40,850 $72,350
$65,000 $42,500 $79,000
$70,000 $42,500 $84,000
$80,000 $42,500 $94,000
$90,000 $42,500 $104,000
$100,000 $42,500 $114,000

Note that for amounts of non-SS income much below that $67K figure (that gives a total taxable income at the top of the 12% bracket), that as non-SS income increases by $5000 we see total taxable income increase by nearly double that, $9000 or so. This means that even though total taxable income is below the top of the 12% bracket, the actual marginal tax rate that one is seeing (that is, the add'l tax one pays as non-SS income goes up by a certain amount) is north of 20%. And I'm not sure I want to be doing Roth conversions at that tax rate.

So I'm curious is this analysis looks right, and if so, how others in similar situations decide what to do (that is, how much add'l non-SS income to generate doing Roth conversions, and possibly LTCG harvesting).
Yes, the calculation of how much SS taxable greatly affects the amount of extra tax paid due to Roth conversion or pre RMD distribution. You are right without SS, 12% bracket is 12% till you move to the next bracket. Once social security is invovled, that bump can be from 12% right to 22% (or even much higher) depending on how much the withdrawal is and if one SS or 2 SS is involved. Need to run a tax calcualtor with SS many times to see when is the threshold.
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RustyShackleford
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Re: optimizing Roth conversion when taking SS

Post by RustyShackleford »

sidneyinplanning wrote: Sat Apr 01, 2023 10:17 am
Yes, the calculation of how much SS taxable greatly affects the amount of extra tax paid due to Roth conversion or pre RMD distribution. You are right without SS, 12% bracket is 12% till you move to the next bracket. Once social security is invovled, that bump can be from 12% right to 22% (or even much higher) depending on how much the withdrawal is and if one SS or 2 SS is involved. Need to run a tax calcualtor with SS many times to see when is the threshold.
Thanks, but moot now. I did take spousal benefits for two years, and then my own benefit at age 70. I'm content.
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