Taxes are generally a concern when transferring funds from a tax-deferred retirement account to a Roth account. Converted funds are treated as taxable current income in the given year, which can push a taxpayer into a higher tax bracket and result in a sizable one-time tax bill. If you are receiving Social Security benefits, this added taxable income could well result in more of your benefits being subject to income taxes if it increased your combined income, a measure used to determine Social Security benefit taxes. The size of the effect depends on size of the Roth conversion as well as any other sources of retirement income besides Social Security.
Talk to a financial advisor to get insight into the pros and cons of Roth conversion.
Social Security Benefit Taxes
Rules on Social Security retirement benefit taxation provide at least partial protection from income taxes on the payments from the federal government. This protection isn't necessarily complete, however. While many Social Security recipients pay no taxes on their benefits, about as many do owe some portion of their benefits to the IRS. Fortunately, at worst, no more than 85% of Social Security benefits may be subject to taxation.
The IRS uses a formula to determine how much of your Social Security benefit may be included in your taxable income. The formula is based on a figured called combined income, or provisional income. To calculate this figure, take half of the annual benefit from Social Security and add it to the adjusted gross income (AGI) shown on your income tax return. This generally includes your W-2 wages and applicable 1099 or small business income, along with investment income. Then add any non-taxable interest, such as earnings from municipal bonds.
Using the resulting combined income figure, refer to this table to see how much of the benefits are taxable. Below a certain level, all Social Security benefits are tax-free. The exact level depends on filing status as shown below:
Roth Conversion Impacts
Performing a Roth conversion by transferring funds from a tax-deferred account such as an IRA to a Roth account can significantly affect current taxes. That's because the converted funds are treated as taxable income. Converting a large amount can push a taxpayer into a higher income tax bracket, further increasing the amount of tax owed.
Because a Roth conversion affects income, it can affect AGI and, for someone receiving Social Security benefits, combined income. If the total of half a recipient's Social Security income, plus their AGI and non-taxable interest exceeds the threshold level for taxation, up to 85% of their benefits may be taxable.
A financial advisor can help you plan an appropriate tax strategy for your goals. Use this free tool to match with an advisor.
Conversion Example With $2,800 Social Security Benefit
For someone receiving $2,800 in Social Security benefits, a Roth conversion could have a sizable effect or no effect on the taxation of their benefits. It depends on their other sources of income and the size of the Roth conversion.
For example, if the taxpayer had only the $2,800 in Social Security benefits for income, none of the benefits would be subject to taxation because their combined income does not meet the threshold for either single or joint filers. If the taxpayer had other sources of income, such as a Roth conversion, however, it could push their combined income over the threshold.
For example, a $50,000 Roth conversion in one year would increase this taxpayer's combined income to $33,600 (the annual Social Security benefit) times 50%, or $16,800, plus the $50,000 conversion amount, for a total combined income of $76,800 that year. At this level, regardless of filing status, tax would be applied to 85% of Social Security benefits. In this case that equals $33,600 times 85% equals $28,560, which is the amount of Social Security benefits that would be taxed.
If the taxpayer had other sources of income, such as income from job, that already increased combined income by $60,000, however, converting Roth funds would not affect the amount of Social Security benefits subject to taxation. That's because the combined income of $60,000 plus half of Social Security benefits or $16,800 would come to $76,800, which is more than the threshold for single or joint filers. Adding more to combined income wouldn’t create more than an 85% taxable rate for your Social Security benefits at that point.
If you’re interested in a professional assessment, a financial advisor can help you do the math and weigh your options based on your goals.
Bottom Line
A Roth conversion would increase your provisional income and, depending on the amount converted, could make up to 85% of your Social Security benefits taxable. For someone whose only income is $2,800 in Social Security benefits, none of the benefits would be taxable. However, a relatively small Roth conversion could expose a portion of their benefits to taxation. If the taxpayer had enough other income to push their combined income above the Social Security taxation thresholds, converting a Roth could have less effect on the amount of their Social Security benefits that are subject to taxation. If the taxpayer's combined income already caused 85% of their Social Security benefits to be taxed, a Roth conversion would not expose any more of the benefits to taxes.
Tips
- A financial advisor can help you decide whether a Roth conversion makes sense for you. Finding a financial advisor doesn't have to be hard. SmartAsset's free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now.
- You can use SmartAsset's RMD Calculator to figure how much any mandatory withdrawals from your tax-deferred retirement account would come to.
- Keep an emergency fund on hand in case you run into unexpected expenses. An emergency fund should be liquid — in an account that isn’t at risk of significant fluctuation like the stock market. The tradeoff is that the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.
- Are you a financial advisor looking to grow your business? SmartAsset AMP helps advisors connect with leads and offers marketing automation solutions so you can spend more time making conversions. Learn more about SmartAsset AMP.
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