Taxation of Social Security: The Tax Torpedo & Roth Conversion Tightrope

earlyretirementnow.com

6 years ago

I was always working under the assumption that once we claim Social Security, 85% of our benefits will be counted as ordinary income on our federal tax return. That may also be a good assumption for a lot of retirees, especially if their overall income in retirement – pensions, capital gains, dividends, distributions from retirement accounts, Social Security, etc. – is high enough. Then, indeed, exactly 85% of your benefits will be taxed. This 85% figure is also the absolute maximum you’ll ever have to include in your federal taxable income. So, as a conservative estimate, it’s fine to use this 85% figure for our retirement cash flow and tax planning.

But in practice, the calculation is a lot more complicated. In fact, that share is calculated through a pretty convoluted formula that takes into account not just your Social Security benefits but also other income, even some ostensibly tax-free income like Municipal bond interest. In the chart below, the x-axis is for the annual Social Security benefits for a married couple filing a joint return (0-$80k), and each line corresponds to a level of all the other income (e.g., pensions, annuities, interest, capital gains, dividends, etc.) also going from $0 to $80,000 in $1,000 steps, so there are exactly 81 lines going from blue via yellow to red. When I plotted this function it looks like the folks at the IRS created a piece of art; that portion in the upper left looks almost like a Bifurcation diagram or Mandelbrot fractal!

The share of Social Security subject to Federal Income taxes (Married filing Jointly). x-axis=Social Security benefits and each line is for a different level of other taxable income (e.g., pensions, annuities, interest, capital gains, dividends, etc.). There are 81 “other income” lines corresponding to income levels from $0 to $80,000 in steps of $1,000.

In any case, for retirement planning, doing a more thorough analysis of our tax on Social Security rather than using the lazy rough estimates has at least four advantages:

The 85% estimate is likely way too conservative so you may over-prepare for retirement and over-accumulate assets. Why not enjoy your money now? Case in point, the Becky and Stephen case study last week; I was way too cautious with the tax assumptions in retirement and underestimated the sustainable, historical fail-safe retirement budget by about $2,500 per year!
The exact calculation of taxes on Social Security benefits has implications on your Roth conversion strategy: There’s no need to be aggressive with your Roth conversions if only a tiny fraction of Social Security is taxable and you have not much other income to fill up your federal Standard Deduction!
But for others, the convoluted formula also has a different, not-so-nice side effect. For some retirees, 401k or Traditional IRA distributions might be taxed at a higher rate than you might think. It’s called the retirement “Tax Torpedo,” more details on that below. So, if you don’t do enough Roth conversions and then later distribute money from a 401k you might face a higher tax burden than expected!
Even some of the ostensibly tax-free income (municipal bond interest or dividends/long-term capital gains in the first two federal tax brackets) may not be so tax-free after all. Because that income is included in the Social Security tax computation, you might face backdoor taxation of seemingly tax-free income. How sneaky!!! It might be optimal to do some tax gain harvesting prior to claiming Social Security!

So, in any case, I will go through some detailed calculations here today, and also link to an easy-to-use Google Sheet I created for you if you want to calculate your own retirement tax estimates. Let’s take a look…

Here’s what the IRS says

To determine the amount of Social Security benefits taxable we’d have to go through an IRS “worksheet.” Ahh, don’t we all love the IRS worksheets? I think some lobbyists from the tax preparer and tax preparer software guild must have taken lawmakers out for lots of expensive steak dinners to push for adding some more of those confusing and convoluted “worksheets” into the tax code. And this one here is a real beauty, see below. For something that really only depends on two variables for most folks (Line 1 – Social Security income & Line 3 – other income), there is a lot of worksheet mumbo jumbo going on, with the annoying “take the smaller or line x and line y” and “subtract line y from line z” language:

This convoluted mess of a table is how the IRS determines how much of your Social Security benefits are taxable.

So, let’s take a look at what this formula spits out in Line 19, i.e., the amount of Social Security that’s taxable, for different values of lines 1 and 3. I plot this as a function of Line 1 (Social Security Benefits) on the x-axis and each line corresponds to a level of Line 3 “Other Income”:

Social Security benefits subject to federal income taxation. The x-axis is for the annual Social Security benefits, and each line is for a different level of “other income” =Line 3 in the IRS worksheet. (Married filing Jointly)

A few observations:

You’ll never pay taxes on more than 85% of your SS income. That maroon line is y=0.85*x.
If you have no other income at all, you can receive more than $60k in SS completely tax-free!
There are several kink points and slopes smaller than 0.85. They are related to the fact that in lines 2 through 17, only half of SS income is factored into the formula and then there are two slopes, 0.5 and 0.85 floating around in lines 14 and 16, respectively. So, $1 more of SS would increase your taxable income by only $0.250 or $0.425.

Also, if we divide the taxable Social Security amount by the benefits, we get the share of Social Security taxable on your federal return again. This is the same chart as above in the introduction, but the “Other Income” steps go from $0 to $80k in $10k steps rather than $1k. Not quite as pretty as the bifurcation plot above, but a little bit easier to see what’s going on.

The same as the above chart, but divided by the Social Security benefit amount. This is the **share** of Social Security that’s taxable. (Married filing Jointly)

What does this all mean for a typical (early) retiree?

OK, OK, information overload. What does this mean for me? And you? Let’s plug in some real numbers into a Google Sheet I prepared. Here’s a numerical example of what I envision a typical (early) retiree couple would look like. But feel free to plug in your own numbers!

A married couple filing jointly.
The number of filers above age 65 doesn’t have any impact on this part of the worksheet, but it will impact your Federal Standard Deduction and your tax calculation downstream. I assume both spouses are 65+.
A combined $30,000 of Social Security benefits. Not a bad assumption for early retirees with only a limited number of years paying into the system.
$20,000 in long-term capital gains and/or Qualified dividends.
$10,000 in other ordinary income: This could be taxable interest, side hustle income, a pension, or 401k/Traditional IRA distributions.
I also assume $0 in tax-exempt interest.
I also assume $0 in lines 5 and 7. But please check with your tax experts if any of those apply to you, e.g., if you’re a “bona fide resident of American Samoa” (see line 5). I mean, I get millions of readers from American Samoa every day, so you better make sure! 🙂

Screenshot from the Google Sheet. Enter the inputs in the orange-shaded fields.

The results are quite stunning. Only a small fraction of your Social Security benefits, around 23%, is even taxable on your federal return! Notice the big difference between the sloppy way and doing it the right way:

The rule of thumb formula: 0.85x$30,000+$10,000=$35,500 of ordinary income would put you above the standard deduction and into the 10% federal income tax bracket!
The correct way would generate only $6,850+$10,000=$16,850 of taxable ordinary income and that doesn’t even fill up your standard deduction! You pay $0 of federal taxes.
(and in both cases, the $20,000 in LT capital gains were also tax-free because they stayed way below the top of the second federal tax bracket!!!)

Also, notice that the total annual retirement budget might even be much larger than the $60k. A portion of your withdrawals from a taxable account would be the tax-free cost basis. Thus, if for example, your $20k in capital gains came from a $40k withdrawal (20k cost basis and 20k capital gains) we’re now looking at an $80k annual retirement budget! Completely tax-free, all due to the way Social Security is taxed and the generous standard deduction. Talking about the standard deduction, this brings us to the next point…

How much “space” do we have to fill up the Standard Deduction?

So, how much of that standard deduction is wasted and how much in other income can we still generate tax-free before we fill up the “0% bracket”? That’s also in the Google Sheet:

Tax calculations in this example: Not only do you pay zero federal taxes. You even “waste” $10,150 in potential ordinary income that would have been taxed at 0%!

Notice that the Standard Deduction is now $27,000: the $24,400 base amount plus $1,300 per spouse over age 65. So, does that mean we can safely earn another $10,150 in ordinary income and still owe zero taxes? Unfortunately not! That’s because for each additional dollar we earn (or distribute from a traditional IRA) we also push more of our Social Security benefits into the taxable bucket! See the chart below where I plot the amount of SS subject to taxes as a function of Line 3 (other income) for different fixed (!) levels of Social Security benefits:

Social Security subject to federal income taxes as a function of your other income (x-axis) for fixed Social Security benefit levels. The 9 lines are for benefits between $0 to $80k in steps of $10k. (Married filing Jointly)

So, how much additional income can we still generate to exhaust the Standard Deduction? It turns out that you can have only about $5,486 of additional income to fill up the remaining $10,150 in the standard deduction. Still pretty cool: we can have $65,486 in taxable income and not face any federal income tax! And add to that your tax-free cost basis in the taxable account withdrawals and you have a pretty sweet retirement budget!

If we like to precisely max out the Standard Deduction (and not a single dollar more!), we can earn another $5,486 in ordinary income! Notice that this is exactly $10,150 divided by 1.85 in this example!

Watch out for the Social Security Tax Torpedo

So, assume now that we’ve filled the standard deduction with additional ordinary income. Our sample retired couple now has $30k, $20k and about $15.5k income from the three major sources Social Security/Dividends and capital gains/Ordinary income. How about if we now increase income beyond that point? What’s the impact on our federal taxes? I calculate that in the Excel sheet below. I simply add three more columns where I increase the 3 different sources (ordinary income, dividend income, Social Security benefits), one at a time:

The marginal tax on ordinary income is 18.5%. It’s not 10% as you’d expect by looking purely at the tax brackets. 10% comes from entering the first bracket but the other 8.5% comes from pushing $850 more of your Social Security benefits into the 10% bracket!
The marginal tax on qualified dividends and long-term capital gains is 8.5%. Not 0% as you’d expect when purely looking at the tax brackets for long-term gains!
The marginal tax on Social Security benefits is only 4.25%. It’s the 42.5% marginal impact on the amount taxable times the 10% marginal tax in the first Federal tax bracket.

The Tax Torpedo! The IRS worksheet causes an extra 8.5% marginal tax on both ordinary income and even ostensibly tax-free income like qualified dividends and long-term capital gains!

The Roth Conversion Tightrope

Let’s look at what that quirky math means for planning Roth conversions. The idea of the Roth conversion is that if our current marginal tax rate is lower than the marginal tax rate we expect on Traditional IRA distributions, then it’s worth converting a Traditional IRA to a Roth today.

So, let’s look at our example of the typical retiree above with the $30k in Social Security and $20k in capital gains. Let’s plot the future expected marginal tax along the ordinary income dimension. We already knew that below the $15,486 mark the marginal tax is zero and then jumps up to 18.5% beyond that point. And once you’ve exhausted the 10% federal bracket and you move into the 12%, that too is multiplied by 1.85 for a total of 22.2%. Ouch! Also, if you look at the chart really carefully you’ll notice that the width of the 10%/18.5% bracket is only about $10,000 wide. How is that possible? Isn’t the width of the 10% bracket supposed to be $19,400 in 2019? Well, that width of the 10% bracket also gets compressed by that nasty 1.85 factor. So, because of the side effect of the ordinary income through the IRS worksheet, you reach the 12% bracket 1.85-times faster. At some point, right about $32,000 ordinary income, the marginal tax falls down again to 12%. That’s where according to the IRS worksheet, line 3 stops having any further effects on the taxable portion of Social Security! Also notice that as ordinary income increases even further, there will be another bump in the marginal rate to 27%. That bump though has nothing to do with the IRS Social Security worksheet. It’s because you push the $20,000 of capital gains into the 15% bracket. I wrote about this effect back in 2016.

Assuming a fixed $30k in Social Security and $20k in dividend income, what’s the marginal tax when varying the other ordinary income (e.g., 401k distributions)?

In any case, what does this all mean for your Roth conversions? You’re potentially walking a real tightrope here:

If you convert too much of your 401k or T-IRA and you push your ordinary income in retirement down so much that you end up in the 0% marginal tax region then you wasted the 12% taxes you paid on the conversion today!
But if you convert too little and your ordinary income gets hit by the Social Security “Tax Torpedo,” i.e., a marginal rate much higher than the 12% you might have paid before claiming Social Security benefits.

This is a very different kind of problem from what I had expected. I already knew that you don’t want to be so aggressive in your Roth conversions today that you end up in a lower tax bracket in retirement. But I also previously believed that you can err on the other side. If you can expect a 12% marginal rate in retirement and pay 12% today, then it’s a wash, right? Wrong. And the reason is the tax torpedo. You don’t want to err on either side. But that “point landing” where you convert neither too much nor too little is impossible to accomplish in light of uncertain asset returns and uncertain future values of your portfolio and thus the uncertain required minimum distributions in the future!

Conclusion

This tax torpedo issue and the implications for the Roth conversions surely is very fascinating! And a lot more complicated than I had thought! In fact, it’s complicated enough that I didn’t even get to where I wanted to take this post today, i.e., an updated recommendation on how to perform the Roth conversions in the Becky and Stephen case study from last week. I’m working on a post (hopefully out next week) to let you know my thoughts on that one, so stay tuned! 🙂

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