Don't Forget Social Security in Roth Conversion

NEW BERLIN, Ill. ( TheStreet) -- With the change to Roth IRA conversion rules last year, there has been a lot of focus on the decisions faced when considering one. One area that often gets short shrift is the future impact on Social Security benefits taxation.

Understandably, this hasn't really hit the radar of most conversion topics; it's important primarily to folks with a much lower income.


The facts
The important figure here is your net adjusted gross income (line 38 minus line 20b on Form 1040) plus half of your Social Security Benefit (line 20a). This is known as your provisional income. If that figure is less than $32,000 (or $25,000 for singles), nothing from your Social Security benefit is taxed. If the amount described above is greater than $32,000 but not more than $44,000 (or between $25,000 and $34,000 for singles), up to 50% of your Social Security benefit will be taxed. If that same figure is above $44,000 (or $34,000 for singles), as much as 85% of your Social Security benefit will be taxed.

I recently dealt with a case where interplay of the Roth conversion with Social Security became a significant factor -- a couple with a low income (less than $45,000 AGI, not including the conversion), who had converted a relatively small IRA (less than $30,000) to Roth last year. Even though they had withheld 10% on the conversion, considering paying all of the tax on the conversion in 2010 caused nearly a $6,000 swing in their tax situation: from roughly $2,500 in tax without paying for the conversion on the 2010 return (delaying to 2011 and 2012), to about $8,500 in taxes if they did pay for the conversion in 2010. Wow!

So how can such a small conversion cause such a huge swing in taxes? Since the couple's provisional income was near $44,000, the Roth conversion bumped up their provisional income to a level where their Social Security was fully (85%) taxable, resulting in additional, unplanned for, income. On top of that, the increase in overall income bumped up the couple's average tax rate to a point where the lion's share of their income was taxed at the 15% rate. Without the conversion, less than one-third of their income was taxed at that rate, with the remainder taxed at the 10% rate.

What to do
Analyzing the tax implications across all three years is important and could yield the best answer. Analysis of the "spread" option showed that this would result in significant taxation of Social Security benefits for the following two years as well, and paying all of the tax in 2010 was the best (least taxed) option versus spreading the tax over 2011 and 2012.

Another alternative is to recharacterize the Roth conversion before your 2010 tax return's deadline for filing (which can include extensions up to Oct. 15). By doing this, your return will show you didn't make the conversion at all, and everything would be back the way it was before the conversion -- no harm, no foul. But you still have that small IRA (and required minimum distributions) to deal with.

In this case, the goal was to eliminate the small IRA and never need to take RMDs again, so the answer was simple but painful: Pay the tax in 2010. By doing so, the couple no longer has to deal with the RMDs from the IRA, and (after 2010), the adverse affect of the conversion will not affect the taxation of their Social Security benefit any longer.

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