Roth conversions are a powerful tool. If you opt to pay taxes on some of your retirement savings today, you could save a lot more in taxes in the future. With the market downturn in 2022, Roth conversions could be a good idea for many retirees.
In fact, they can help you boost the amount of Social Security retirement benefits you take home. If you're not careful, though, an ill-timed Roth conversion could come with a shocking tax bill.
Here are two ways a Roth conversion can help boost your Social Security benefits and one way it can absolutely ruin them.
Act now for more control later
One of the big advantages of a Roth IRA over traditional retirement accounts is that they don't have any required minimum distributions. Traditional IRAs and 401(k)s force retirees to take distributions starting at age 72. The amount of those distributions is based on a combination of their age and their account balance at the end of the previous year.
If you have a big balance in your traditional IRA, you may end being forced to take more than you really need from your account. Since all distributions from an IRA count toward your income tax, you could face a substantial tax bill.
That's made even worse by the taxability of Social Security. When you combine a big IRA distribution with Social Security, more of your Social Security benefits could become taxable. In other words, the government will reduce your Social Security benefits to pay those taxes.
If you convert a good chunk of your traditional retirement accounts to a Roth account, you'll be able to avoid big required minimum distributions. This strategy is most useful before you start collecting Social Security to avoid a high tax bill in retirement.
Roth distributions can keep Social Security tax free
Once you have funds in a Roth account, you can withdraw the funds without any implication on your taxes. Roth distributions will not increase your income in the eyes of the IRS, so you can keep your income very low and keep your Social Security income below the thresholds where it becomes taxable.
One of the best ways to use your retirement accounts in retirement is to mostly use your pre-tax accounts before you collect Social Security and mostly use the Roth accounts after you start collecting. The more you can get into the Roth before filing for Social Security, the more likely you are to keep more of your benefits tax free, increasing your monthly checks.
Be careful converting while collecting Social Security
A Roth conversion while you're collecting Social Security benefits can come with a much higher tax bill than expected.
A Roth conversion requires you to pay income taxes on the full amount converted. But when you convert funds, you can also increase the amount of Social Security that becomes taxable.
Imagine a married couple that lives on $66,000 per year, and $36,000 of that comes from Social Security, with the rest from retirement accounts. They'll have a tax bill of about $1,350.
The couple sees it has around $60,000 worth of room in the 12% tax bracket and figure that's a good deal to convert. However, if they convert that $60,000, the amount of taxable Social Security benefits increases from $9,400 to $30,600. And in fact, they've pushed themselves into the 22% tax bracket.
Their tax bill with the $60,000 conversion is actually $12,068, $10,718 higher than their previous bill. That's an effective tax rate of 17.9% on their $60,000 conversion that they expected to come in between 10% and 12%.
The impact could be even worse if the couple also has capital gains that were taxed at 0%, but the conversion pushes them into the 15% tax bracket.
As you expand into multiple sources of income with different tax treatments, you must become more mindful of tax planning. The best way for retirees to prevent a big tax surprise when they start collecting Social Security is to get as much money into a Roth account before they file for benefits.