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Now Is the Time to Make This IRA Move to Avoid Taxes on Social Security

By Christy Bieber – Updated Jul 14, 2020 at 10:06PM

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Taxes could take a big bite out of your retirement income if you don't act.

Social Security benefits are an important source of retirement income, but unfortunately, as many as 50% of current retirees lose a collective $38.9 billion each year to federal taxes. That's because at least a portion of all Social Security benefits are taxed once your income hits a specific (pretty low) amount. 

If you don't want to resign yourself to living on a low income or paying a big tax bill, you do have another option: You can convert your retirement accounts to a Roth IRA. And now is an ideal time to do it. Here's why. 

1040 tax form with check from the treasury sitting on top of it.

Image source: Getty Images.

How a Roth IRA conversion helps you avoid Social Security taxes

First things first: You need to understand why converting to a Roth enables you to avoid Social Security taxes on your benefits. 

The key factor is that your benefits become partly taxable only when you have countable income above $32,000 for married joint filers or $25,000 for everyone else. But not all income is countable. In fact, income for determining if you'll owe taxes on your Social Security benefits equals half of your Social Security check amount plus taxable income from other sources. 

Distributions from a Roth IRA, however, are not taxable income. That means you can take as much money out of a Roth IRA as you want, and it will not affect taxes you owe on Social Security. 

Why it's an ideal time to convert your IRA to a Roth

Both workers and current retirees can convert a traditional IRA to a Roth IRA. However, there are tax consequences associated with the conversion. Specifically, you have to pay taxes on the converted amount in the year you make the change. And for current retirees considering a conversion, it's important to realize the converted funds could push your income above the threshold at which your benefits are taxed, resulting in more of your benefit going to the IRS. 

Still, despite these tax consequences, it can often be worth it for future retirees and sometimes for current retirees to make the switch. And if you're considering it, now may be an especially opportune time for a few reasons. 

If you sustained losses when the coronavirus crashed the market and your investments haven't fully recovered yet, your IRA account balance may be lower than it was a few months ago. You can take advantage of the opportunity to move your money over now, when you have less of it, so you owe less taxes on it. Then you'll benefit from the tax-free growth the Roth offers as your investments recover. 

Because you're allowed to take up to a $100,000 penalty-free distribution from your retirement accounts this year even if you're under 59 1/2 (if the distribution is related to financial hardships caused by COVID-19), you also have the option to use some of the money from your IRA to pay taxes due (otherwise you'd have to come up with that cash from another source). The CARES Act also allows you to defer the payment of taxes on your distribution over three years, or to pay back the money over that time without affecting future contributions (in which case you wouldn't owe taxes at all). So you could essentially borrow some of the money to cover the tax bill and put it back over the next few years.  

And if you earn less money this year due to coronavirus cutting your hours or otherwise affecting your job, the fact that your conversion raises your taxable income may not have as profound an effect as it would in years when you make more. If you're normally in the 24% tax bracket, for example, and this year you're in the 22% bracket (even with the extra income you're taxed on due to the conversion), you'd owe less in tax on the money you're converting. 

Should you do a Roth conversion to save on Social Security taxes?

Because there are serious tax consequences associated with converting to a Roth IRA, you'll need to carefully consider whether this move makes sense for you. Retirees who plan to take money out soon also need to make sure they understand the five-year rules, which could trigger penalties on withdrawals made within the years after the conversion happens. 

To make your choice, consider the amount of taxes you'll have to pay on a Roth conversion and compare that to the amount you'll save on Social Security taxes each year. If you can realize enough savings and can afford to pay the taxes due on the conversion, now may be the ideal time to act. 

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