Traditional IRA distribution taxed at 46.25%
Another reason to pursue Roth conversion vigorously (as if the low prices weren’t enough already): a distributed TIRA dollar is taxable income, and may well add a dollar to the portion of Social Security which is taxable. At a marginal rate of 25%, that’s 25% on the TIRA dollar PLUS 25% of 85% on the SS dollar. So, take out a dollar, keep 54 cents. I guess I’m a bit dense as I only realized this a few months ago, it seems rarely mentioned in discussions of conversion or taxation. I just finished reading the otherwise very good “The Retirement Savings Time Bomb” thinking that this angle would be discussed but it’s not. Here’s a link to a page at Prudential: http://www.prudential.com/view/page/11684?seg=7&name=retirementplanning see the title “Innovative Strategies to help Maximize Social Security Benefits” Here’s a direct link to the paper: http://www.prudential.com/media/managed/IB-InnovativeStrategies.pdf Thanks to the authors James Mahaney & Peter Carlson
Permalink Submitted by Alan Spross on Sat, 2009-01-17 00:06
It’s correct that you would multiply your marginal rate by 1.85 for the income tier in which SS benefits are added to AGI. However, the majority of Roth conversions are being done by those who already have some or all of their SS income included. Since the threshold for SS income @ 50% has been in place since 1983 without any indexing, most people with retirement accounts are now caught up in at least part of the income inclusion. Back in the 80s, most SS income was not taxed.
In the early 90s, the 85% tier was added to the 50% tier, and now this tier also has caught many, thus the 1.85% factor. Note that the marginal rate returns to the unadjusted rate once 85% of SS dollars have been included in AGI. In theory the untaxed 15% represents the portion of an average benefit generated by the employee’s after tax contributions, and essentially eliminates double taxation. In theory….
Strategies for deferring SS benefits work well for retirees who have enough taxable savings to pay for conversions. With an 8% bonus per year after normal retirement age, lifetime benefits are increased while keeping the inflated marginal rates from hitting converting taxpayers. In extreme cases, the return of SS benefits can also be applied to eliminate the SS income in the conversion years.
I would not expect with the deficit as it is that the thresholds will be indexed for inflation, and therefore they will catch more and more taxpayers every year. If someone is already taking SS benefits, it may actually pay to convert larger amounts every other year so that the 1.85% factor only hits every other year as well. The detailed modeling is very complex since even Part B Medicare premiums can be surcharged based on income produced by conversions. It’s all another reason not to overdo conversions. Being overly aggressive is a hedge against asset accumulation success, while under converting is a hedge against the kind of economy and markets we presently have.