What you haven’t heard before about the taxation of Social Security benefits

[NW-Bound]

Quote:

Originally Posted by pb4uski ... I think part of what you may have been missing is the 5% tax-free growth of the Roth IRA.

+1

I have been doing an example spreadsheet, and am about to make a post when I see that someone else already explained it.

If the tax rate that you are paying for the tIRA-to-Roth conversion amount is the same as the future tax rate on tIRA withdrawal at RMD, then it is a wash. If the former is lower than the latter, then you've won by doing conversion.

Another thing to consider is that even if the two tax rates are equal, Roth IRA has the advantage of having no RMD, hence gives you some flexibility if you are going to leave something to your heirs.

[Animorph]

Quote:

Originally Posted by NW-Bound +1 I have been doing an example spreadsheet, and am about to make a post when I see that someone else already explained it. If the tax rate that you are paying for the tIRA-to-Roth conversion amount is the same as the future tax rate on tIRA withdrawal at RMD, then it is a wash. If the former is lower than the latter, then you've won by doing conversion. Another thing to consider is that even if the two tax rates are equal, Roth IRA has the advantage of having no RMD, hence gives you some flexibility if you are going to leave something to your heirs.

Even if the tax rates are equal for Roth conversion and tIRA RMD's the Roth comes out ahead because of the greater after-tax value the Roth shelters from taxes. That makes it worth Roth converting at 25% tax rate if RMD's are going to come out at 25% tax rate. Providing that the Roth conversion taxes are paid with taxable funds and the full tIRA withdrawal is Roth converted.

[NW-Bound]

The biggest problem with making long-range planning for income optimizing and tax reducing is not potential tax code change but the unknown future investment returns.

FIRECalc says that at my current WR, by the time I get to IRA RMD age, the expected or average value of our IRA/401k will push us deep into the 25% tax bracket. And that is without taking SS early.

So, under the average scenario, if we take SS early we will spend less on IRA and will have even more at RMD age. The even higher RMD can push us past the 25% bracket into the 28% bracket.

If we do not take SS early, than the higher SS + lower RMD can still get us to the 28%.

Which of the above scenario is better? I guess I need to check into finer details. I am going to delay that for a few years as I cannot touch SS yet. I cannot even touch IRA (except for Roth conversion) as I am not yet 59-1/2.

One thing I have thought about, which appears to be a sure thing is Roth conversion. It looks like one either breaks even or wins with that strategy.

[walkinwood]

Quote:

Originally Posted by Running_Man I must admit I do not understand the logic, here is why, what do I have wrong? If one where to convert to a Roth @ 30K per year for 10 years between age 60-70 you will subtract 300K from the portfolio and lowered the required RMD. However at age 70 only about 4% of that would be subject to withdrawl or 12K on the 300K you reduced and a tax of 25% that is $3,000. However you would have paid tax at 15% total or $45,000 and permanently lost the earnings on that amount. Just in the 10 years this would have been implemented you would forgo earnings of $14,081 at a 5 percent return and $28,987 at a 7 percent return. Along with the 45K of tax paid this is 20 years to make this back up, excluding the effect future earnings foregone on the already taxed portion past age 70 . What am I seeing wrong?

But you'll have to pay tax on the delta amount in the IRA every year after you turn 70 & it will increase as your RMD %age increases. And you haven't taken the increase in the value of the $300,000 in 20 years. Right?

[NW-Bound]

Quote:

Originally Posted by Animorph ... Providing that the Roth conversion taxes are paid with taxable funds and the full tIRA withdrawal is Roth converted.

But that money drawn from taxable funds to pay taxes could have been left there to accumulate capital gains, which can be tax free if one is in the right bracket.

There are so many moving parts! I think the gummint, either knowingly or inadvertently, has created these complex tax codes so that the citizens spend all their time trying to "optimize" their taxes, and keep their nose to the grindstone keyboard and forget to protest. Good diversion, that.

[pb4uski]

Quote:

Originally Posted by NW-Bound .....I think the gummint, either knowingly or inadvertently, has created these complex tax codes so that the citizens spend all their time trying to "optimize" their taxes, and keep their nose to the grindstone keyboard and forget to protest. Good diversion, that.

Knowingly? You're kidding, right? They aren't that smart.

[NW-Bound]

I dunno. One thing I have learned over the years is not to underestimate the other guy.

[Lsbcal]

You guys are making me laugh. Time to go to bed.

[Independent]

Quote:

Originally Posted by Running_Man Is the tax really all that severe? Lets assume at age 70 single male will need to RMD 4% of a million dollar portfolio. Also start taking SS at 3K per month or 36K per year giving a 76K annual income. At 40K of income and 36K of social security for a single person the additional taxable income would be: Test 1: 85% of 36,000 = $30,600 Test 2: 1/2 SS Benefits : $18,000 Combined Income $58,000 Less second threshold $34,000 Excess above 2nd threshold: $24,000 85% of excess: $20,400 TOTAL TEST 2 $38,400 Test 3 Provisional Income $58,000 Less 1st threshold 25,000 Excess above 1st threshold 33,000 50% of excess above 1st thresh 1 6,500 35% of excess above 2nd thresh 8,400 Total Test 3 $24,900 equal 69 percent of SS Taxable income would be $64,900 less standard deduction of $6,500 and personal exemption of $3,950 leaves taxable income of $54,450 and a tax for a single of $9,468.75 or 12.5% of total income based on 2014 rates. This is 23.67 percent of the total 401K withdrawl so to take an early 25% tax for a single to convert to an Roth IRA would make very little sense in this case, and if you are making a lot more than this I think you should be patting yourself on your back for being better than 90% of all other retirees. An excellent article I loved it

The complexity here is that the marginal tax rate includes not only the tax on the IRA withdrawal, but also the additional tax on SS that the IRA withdrawal generates.

That sounds confusing. The simple thing is to run the same math you've done above, but with a $30,000 IRA withdrawal. I think you'll find that your FIT is about $4,600 lower than it is with a $40,000 IRA withdrawal.

That's a marginal rate of 46% on the extra $10,000.

What's happening is that the IRA withdrawal is taxed at about 25%, for $2,500 In addition, the extra $10,000 of IRA withdrawal makes an additional $8,500 of the SS benefit taxable, for another $2,125.

If I knew that I was going to be in exactly this position after RMDs kick in, then trad=>Roth conversions prior to 70 would make sense when I'm in a 25% marginal tax bracket.

Of course, it's hard to know 10 years in advance that I really will be in exactly this situation.

[Independent]

Quote:

Originally Posted by NW-Bound There are so many moving parts! I think the gummint, either knowingly or inadvertently, has created these complex tax codes so that the citizens spend all their time trying to "optimize" their taxes, and keep their nose to the grindstone keyboard and forget to protest. Good diversion, that.

I'm thinking about human nature. Let's imagine two tax systems.

1. A very simple system where it's easy to see that I will pay $10,000.

2. A very complex system, where it looks like I could pay $15,000 if I take the easy route. However, by studying the tax law, maximizing deductions, tax deferrals, etc. I can get my taxes down to $10,000.

Personally, I'd prefer 1. However, I think a lot of my fellow voters really prefer 2.
Maybe they wouldn't say that if the two choices were laid out this clearly, but in practice, the $10,000 payment is more palatable in the second case because they figure they "out-smarted" the tax guy.

[Lsbcal]

Quote:

Originally Posted by Independent The complexity here is that the marginal tax rate includes not only the tax on the IRA withdrawal, but also the additional tax on SS that the IRA withdrawal generates. ...

Right there is a bump in the marginal tax rates. Many will find it doesn't matter because their combined income sources including RMD's push them well above where SS gets the 85% full taxation.

Especially when we factor in IRA account increases due to investment performance and inflation (inflation up, bond rates up, more $'s in account). As has been mentioned above, FIRECalc has many upward sloping outcomes. Those outcomes don't even factor in the inflation (they are inflation adjusted outcomes). For instance, 15 years at 2.5% inflation makes a dollar go to $1.45. So you might even be loosing in the investment game and still getting higher RMD's due to inflation.

I don't think RMD's are adjusted at all for inflation. Just tax rates.

[Running_Man]

Thanks to everyone that applied I see the error in my logic now.

[NW-Bound]

Quote:

Originally Posted by Independent I'm thinking about human nature. Let's imagine two tax systems. 1. A very simple system where it's easy to see that I will pay $10,000. 2. A very complex system, where it looks like I could pay $15,000 if I take the easy route. However, by studying the tax law, maximizing deductions, tax deferrals, etc. I can get my taxes down to $10,000. Personally, I'd prefer 1. However, I think a lot of my fellow voters really prefer 2. Maybe they wouldn't say that if the two choices were laid out this clearly, but in practice, the $10,000 payment is more palatable in the second case because they figure they "out-smarted" the tax guy.

Exactly. Hence people do not like to see a simpler tax system because they would be losing their precious "deductions".

“The art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing” -- Jean Baptiste Colbert quotes (French Economist and Minister of Finance under King Louis XIV of France. 1619-1683)

[kaneohe]

Quote:

Originally Posted by NW-Bound There are so many moving parts! I think the gummint, either knowingly or inadvertently, has created these complex tax codes so that the citizens spend all their time trying to "optimize" their taxes, and keep their nose to the grindstone keyboard and forget to protest. Good diversion, that.

I have been w/ the AARP Tax-Aide program preparing taxes primarily for seniors for a number of years. I've seen many folks who come in who just have SS and a small bank account w/ a little interest. Makes you wonder how they can survive. They pay little or no taxes. Based on that, I have a simple-minded theory that the gummint by design decided that the poor should not pay very much, if any, tax on their SS and those who were more well off should pay more. If you are in the latter category, you can think of this situation in one of 2 ways:

1) You are just paying your normal tax on your SS income. In fact you are
being given a break because at max only 85% of your SS is taxed........and
if you earn less, even less of your SS is taxed.
OR
2)you can think of it starting at low income and make yourself miserable thinking about marginal tax rates of 27+ and 46+% instead of the tax bracket rates of 15/25%.

Most of us here of course love to optimize things so , in my mind anyway,
we create the complexity for ourselves.

[Lsbcal]

Quote:

Originally Posted by kaneohe ... Most of us here of course love to optimize things so , in my mind anyway, we create the complexity for ourselves.

I'm guilty as charged. Sometimes I have to step back from complexity and smell the roses.

[NW-Bound]

Quote:

Originally Posted by kaneohe I have been w/ the AARP Tax-Aide program preparing taxes primarily for seniors for a number of years. I've seen many folks who come in who just have SS and a small bank account w/ a little interest. Makes you wonder how they can survive. They pay little or no taxes. Based on that, I have a simple-minded theory that the gummint by design decided that the poor should not pay very much, if any, tax on their SS and those who were more well off should pay more.

Independently from the progressive nature of the tax system which I myself agree with to some degree, the tax codes need some simplification to bring more transparency.

The way it is, two persons with the same income may pay two vastly different amounts, depending on the nuances that they shape their financial matters. I don't think that is healthy. For example, the home mortgage deduction and tax-free treatment of home appreciation were two factors that encouraged people to buy McMansions, leading to the housing bubble.

[haha]

NW, the government will never let these carrots and sticks go, because they live to control people. Nothing but puppet masters.

Ha

[Lsbcal]

Quote:

Originally Posted by haha NW, the government will never let these carrots and sticks go, because they live to control people. Nothing but puppet masters. Ha

Well I'm certainly not a puppet, no strings attached here ... hey, stop raising my arm like that ...

[Midpack]

Quote:

Originally Posted by kaneohe Most of us here of course love to optimize things so , in my mind anyway, we create the complexity for ourselves. Quote: Originally Posted by Lsbcal I'm guilty as charged. Sometimes I have to step back from complexity and smell the roses.

+1, guilty here too. But running through the exercise and not coming up with THE answer is often what it takes for me to get comfortable letting go. So it's often not a waste of time (not that the OP said it was). A valuable part of learning for me...

[NW-Bound]

Stop to smell the roses and miss out on mucho tax breaks?

Not this scroogy guy! I have to go with the flow.