Roth Conversion Amount Considered Income for SS Purposes
I will begin receiving Social Security in January 2011 at age 62. In January 2011 I am also planning on converting about $50,000 from a Traditional IRA to an already existing Roth IRA I have. I know the conversion amount is considered income and is taxable. Is it also considered income for Social Security income purposes and I will start losing $1 for every $2 over the $14,000 limit? I believe that IRA distributions are not considered income for that purpose but this is a conversion not a distribution. Thanks.
Permalink Submitted by Alan Spross on Sat, 2011-11-12 20:44
I assume where you show 2011, you really mean 2012.
The SS earnings test applies to earned income from salary or self employement, not to other forms of income such as distributions from IRAs or conversions. A conversion is technically a two part transaction, first a distribution and then a rollover to a Roth IRA. In any event, any IRA related transaction you do or other income such as capital gain or dividend income are NOT earned income and therefore will not cost you any SS benefits under the earnings test. That’s the good news.
However, your taxable conversion income WILL cause 85% of your SS income to be included in your AGI. If your SS income otherwise was not included, this will trigger a high marginal tax rate while your SS income is being added to AGI. For example, if you are in the 15% bracket, while SS is being added to your AGI as a result of this conversion income, the actual marginal rate you will pay is 1.85 X 15% or 27.75%.
You might pick up some tax software before you convert and run some scenarios using different conversion amounts. By converting less, you may be able to reduce that 85% down to 50% or even lower. You should avoid converting at marginal rates that will be higher than your expected marginal rate in retirement.
Permalink Submitted by Jim Tully on Sun, 2011-11-13 00:00
Thanks for your quick reply. You’re right, I meant 2012. I have been retired for a number of years already and have a pension of $80,000 a year. Wife is retired and also has a pension of a similar amount, so 85% of my SS will be taxed anyway. I plan on looking at the tax brackets and my 2012 income before deciding on the conversion amount so I don’t have some at a higher bracket than I’m already in. I’d like to convert about $120,000 over the next 2 or 3 years. I also sometimes have a little self employment income, usually less than $5,000 which I have to consider. Thanks again for your help.
😀
Permalink Submitted by Alan Spross on Sun, 2011-11-13 00:57
With 85% of SS included regardless, the decision is easier to analyze. Nonetheless, you might be a good candidate to use one of several conversion strategies since you will be working with significant amounts. Here are some of the options:
1) Figure out the amount to convert in advance as discussed (simplest option). This avoids recharacterizations.
2) If pre calculation is a challenge, just convert an amount sure to be in excess of the optimum amount, then recharacterize part of the conversion to return to the exact optimum amount when all your other income totals are in. This might be done in March, so you do not need to extend your return.
3) Do as 2) above, except do two such conversions instead of one. Recharacterize the entire conversion with the worst performance and part of the best one to get to the optimum amount. You might invest one very aggressively to attempt to get large gains, and the other in very stable value investments. That way, you will be assured of using your current year bracket with the best of the two, figuring the stable value conversion will not lose much and will be a keeper. And if you overshoot your tax bracket target, it may still be worth retaining a greater conversion amount if the gains are significant enough. Gains can reduce the effective tax bill on a conversion.
With the multiple conversion strategy, once the recharacterization deadline passes, you can always change the investments from aggressive to more conservative, since at that point you can no longer recharacterize the conversion.
If you want to extend the recharacterization decision from March to September, then you should file an extension in April. You can also file your actual return and then amend it if you recharacterize. The only requirement to qualify for the extended due date (10/15/2012) is that you must EITHER file your return by 4/15 or file an extension by 4/15.