I’m 65 with $1.7 Mil What’s the Relationship Between Social Security, Taxes, IRAs, Roth Conversions

I’m 65 with $1.7 Million in my retirement portfolio, what is the relationship between Social Security, Taxes, IRAs, and Roth Conversions? What retirement income strategies should I use to reduce the taxes I pay in retirement? What are the best methods to maximize my social security? In this video, Troy Sharpe explains the relationship between your social security, taxes, IRAs, and Roth Conversions.

 

Two Scenarios:

Troy Sharpe: In the two scenarios behind me, we see an estimated difference in ending value of over $1 million. The only difference in these two scenarios is when we take Social Security, what we’re doing from a tax planning perspective, and when and where we withdraw income from in retirement. If we see here, an estimated ending value of $3.1 million versus $2 million over here, this is the path that most people are heading down when they first come to see us at Oak Harvest Financial Group. It’s called the conventional wisdom sequence.

It’s called that because people have been doing it this way for decades. It’s taking Social Security typically when you retire, deferring your IRA accounts out as long as you possibly can, and then living off your non-IRA assets. When oftentimes it makes much more sense to go down a different path where we’re having a more strategic approach to when we’re taking Social Security, how much and from which accounts we’re withdrawing income from, and also a very targeted approach with tax planning.

We’re going to talk about the relationship of IRA withdrawals, Roth conversions, how do we get into a position to pay less tax and Social Security and how all of those things are interrelated as well as some other important concepts that are going to help you make better decisions in retirement.

Troy Sharpe: Hi, I’m Troy Sharpe, CEO of Oak Harvest Financial Group, Certified Financial Planner professional, host of the Retirement Income Show, and a Certified Tax Specialist. Usually when people reach out to us, it’s when they hit this point, I call it the light bulb moment where all of a sudden the realization sets in that every single decision we make in retirement is interrelated.
It impacts another aspect of retirement. Either you’ve been trying to do this yourself and you finally realize, “Hey, this is a lot, and I don’t understand the tax code and how all these different pieces move together” or maybe you’ve been working with another firm and you just don’t feel like you’re getting the level of planning that you need at this point in your life. This is typically when people reach out to us.

When we talk about tax planning and income planning, and when we take Social Security, I want to try to help you today to understand some of the more nuanced concepts so if you do decide to continue doing this yourself, you have a little bit more of an advantage to making better decisions. If you decide, “Hey, I don’t want to do this myself,” if you want to, feel free to reach out to us. A lot of times what we see is when someone is thinking about doing Roth conversions, they typically want to target a specific tax bracket.

Now, that may or may not be right for your particular situation, but there are concepts that you need to grasp in order to help identify how much is the correct amount to do. These concepts are called add-ons and reductions. The way the tax code is created, it’s extremely complex, it really is just a giant mess, but what happens is if we take one more dollar of income, that dollar isn’t always tax by itself. A lot of times it can bring other dollars into the situation that are also tax. This is what we call an add-on.

Conversely, whenever we have a distribution from a Roth IRA later in life, if we’re not paying tax on that, it can help reduce other income that may be taxed. Now, specifically I’m talking about Social Security here. Social Security is a pretty complex formula for how it’s actually taxed. Anywhere from 0% to 85% of your Social Security is subject to income taxation so understanding the concept of add-ons and reductions, when we do a Roth conversion, are we adding another dollar of Social Security into the income tax situation, because we would need to calculate that in regards to the true cost of the conversion.

Again, on the other side of that coin later on in life, what is the benefit if we do the Roth conversions today? Are we saving from Social Security taxation, income taxation, possibly IRMAA adjustments, which is what we call an income-related monthly adjustment amount for your Medicare premiums, and then also net investment income tax, which could be an additional tax on your capital gains and dividend? Not to mention anything that may be created legislatively over the next 5, 10, 15, 20 years to where if you hit a certain level of income, now they’re bringing other add-ons into the picture.

I doubt they’re going to bring many reductions into the picture, but that’s up to us to help build a plan that protects from those types of things impacting you negatively in the future. Okay, we have two scenarios right here. This is the conventional wisdom, just want to show you here. High level, projected values, taxes going down this path, $800,000 versus a more strategic approach, $266,000. Let’s call it about a $550,000-$540,000 difference in taxes paid, but it provides a much higher estimated ending value at the end of the retirement plan, $2 million over here versus $3.1 million so an additional $1.1 million in your account balances by taking a more strategic approach here.

Now I want to jump into the analysis of the base case and show you some of these add-ons and reductions when we do the comparison so you can start to not just conceptualize but actually see with numbers and dollars what it is I’m talking about. In both of these plans, everything is identical except the amount we’re doing Roth conversions, when we’re taking Social Security, and from where and how much IRA, non-IRA, Roth IRA we’re making withdrawals for retirement income. The spending plan in both of these is $100,000 per year, increasing over time for inflation.

The longevity is 30 years so retirement date until plan expiration. Everything is the same, the only thing we’re looking at here is planning and to create the difference in estimated ending value and reduction in taxes. Here is just a visual breakdown of the composition of the account. It’s $400,000 in what we call a non-qualified account. That’s a taxable account either in the bank or a brokerage but outside of an IRA.

Then we have his IRA and her IRA represented by the blue and the green. Here is the base plan, we see the deferral of the IRA, the tax-deferred dollars, we’re not taking any withdrawals out. This is what we call an over time withdrawal plan. With the base strategy over time, what is the withdrawal strategy? Well, pretty simple. We’re deferring the IRAs, and we’re starting to take out of the taxable account, the non-IRA account, while also taking Social Security.

In this example, both husband and wife are 65 years old, retiring right now, January 2023, they want to start taking income out of the portfolio as well as turning Social Security on. Now I have a long-term comparison pulled up of the two different strategies. The first one, instead of trying to target a specific tax bracket, like many people do, maybe 12%, maybe 22% or 24%, we’re not looking at a specific tax bracket because that overlooks the concept of add-ons and reductions.

What happens to be the number 1 ranked strategy right now, and typically number 1 through number 10, they’re really fairly close so it’s really a year-to-year conversation and analysis that we have, weighing the pros, weighing the cons, and then making a decision for what’s best for the plan at that given time. The top-ranked strategy right now, we see Social Security is being deferred versus Social Security being taken at 66 over here.

Now, if we were to do Roth conversions while also taking Social Security early, when we’re doing that extra conversion, we’re bringing more of Social Security into the picture, but the base case, the conventional wisdom is we defer retirement accounts and we pull from the non-IRAs. Really from a tax planning perspective, we just have to monitor and manage capital gains, dividends, and interest from the taxable account. Because we’re not taking IRA withdrawals from this strategy, we don’t have to worry about that bringing Social Security into the picture, only if we decided to do Roth conversions.

Now, over here with the more strategic approach, we are deferring Social Security while doing Roth conversions, and I’m going to show you the amount of the conversions in a minute, but the concept is not how much are we doing in Roth conversion, the concept is by deferring Social Security and doing Roth conversions, we are not having add-ons right now. Meaning if we took Social Security and did the conversions, not only are we paying tax on the conversions and possibly the income that we need, but now we’re also bringing more Social Security into the taxation picture.

Because remember, if planned appropriately, anywhere from 0% to 85% of your Social Security income can be subject to income tax, and if done right, we can be close to 0% of your Social Security subject to income tax. That’s the first concept. Instead of looking to see a base analysis, and I see this all the time, even with financial advisors, when I have this conversation with them, they’ll say, “Troy, if the conversion costs 22% today and it’s going to cost more than 22% in the future to take those dollars out of the retirement account, then people should do the conversion today.”
The other side of that coin would be well, if they do a conversion and it costs 22% today, but in the future, it’s going to be 12%, when they take money out of the retirement account, then they shouldn’t be doing conversions today. While that could possibly be correct, it is an incomplete analysis, we have to take into consideration these add-ons and these reductions in regards to the overall tax plan.

To summarize, we have the base strategy here where we’re taking Social Security at 66, pulling from non-IRAs, not doing Roth conversions. If we did Roth conversions the same time we were taking Social Security, we would have this concept of add-ons because when you convert $1 and it bumps you into another taxable range, it can bring another dollar of Social Security into the income tax calculation as well so it actually costs more. Over here, part of this strategy is not only doing conversions but it’s also deferring Social Security.

Those two strategies are working together as one because what it’s going to do is avoid any add-ons now where more Social Security is being taxed, thereby increasing the cost of conversion, but on the back end, it’s going to take into or it’s going to provide us a lot of reductions because we’re going to be able to have a significant amount of income. If we look at Social Security out here, it’s over $100,000 a year, and the total taxes that we’re paying are around $5,000.

Now, this does take into consideration required minimum distributions because we’re not converting all the retirement accounts in this strategy, and also, of course, Roth IRA distributions. With this strategy, I know it’s getting kind of deep here, it has a lot of benefits when we look at the cost of additions and reductions, because Social Security, it’s not being brought into the picture sooner, and later on in life, it’s significantly tax-free, and we’ll look at those numbers very closely in just a minute, but also, we’re getting out of IRMAA brackets, we don’t have to worry about our modified adjusted gross income or the surtax on Medicare premiums. We also don’t have to worry about net investment income tax.

Okay. Now, before we look at these add-ons and reductions, I want to just show you the comparison down the full schedule. Base strategy, we can pay zero taxes, take Social Security, which a lot of people do, this is our estimated before-tax account balance, but we see what taxes look like down the road. This has taken into consideration taxes on your income, from Social Security, your required minimum distributions, and your capital gains and dividends.

Estimated account balance, if we just look at age 85, we have 2.3 versus over here, about 2.3, so that’s kind of roughly your break-even point, maybe a little bit before, if the only thing that mattered was account balance. Primarily, I want you to see the taxes throughout the rest of retirement compared to over here. Now, something to consider when it comes to taxes, it’s not just the amount of taxes you pay, in my opinion, it’s the tax risk you carry.

When you have more and more money inside of retirement accounts in your plan, if you’re following the conventional wisdom, you are deferring everything, kicking it all down the road, what you’re doing is you’re introducing the concept of tax risk to your retirement, where if we eliminate the large amount of potential future taxation now, we’re diversifying from that tax risk or essentially we’re really getting rid of it, because over here, if we can have this level of Social Security on top of the required minimum distributions, income over here is around $150,000, $170,000, $180,000, but look, we’re paying very, very little tax.

We’ve taken that tax risk off the table. If taxes go up, if the income brackets change, if they add something new into the tax code, that’s not a risk you have to worry about anymore. One of the more kind of, maybe intangible isn’t the right word but the concept is something that we can’t see, something that’s not there, something that may be there in the future, we’re eliminating that possibility from even being a consideration when it comes to this type of planning right now, today.

Okay, now I want to show you these add-ons and reductions for both scenarios. One of the biggest problems we have when it comes to the conventional wisdom sequences, future required minimum distributions. We see $50,000, $100,000, $150,000 required minimum distributions that start at age 72. We see the chart here. We start to get into a situation where the amount of money you’re forced to take out of the retirement account creates add-ons with Social Security and also potentially IRMAA, which is the Medicare surtax, and maybe even net investment income tax, which is a 3.8% additional tax on capital gains and dividends if your income reaches certain thresholds.

It’s not if we’re going to pay taxes, it’s how much are we going to pay and when are we going to pay those. This would be a withdrawal plan, this is the schedule of accounts that we would withdraw from and estimated amount we would need to withdraw in order to achieve the planning objectives, which is spending the amount of money we need for a comfortable lifestyle. Base strategy, we just simply see the the accounts, the IRA is being deferred, and then we get to where we have to start taking money out.

Once we have to start taking money out, we’re kind of in that no man’s land where, “Okay, whatever our Social Security is and whatever the RMD is, that’s taxable income that we’re going to have to deal with.” Base strategy, I want to focus on age 75 here. At 75, this is what we call a funding sources table where it’s looking at all of the income that’s projected to come in the future, Social Security, account distributions, required minimum distributions, any pensions, just a real quick table we use to analyze your future income.

Age 75 is over here. We have $70,000 of Social Security income, $74,000 of required minimum distributions, and then $56,000 of other distributions. This is coming from the non-IRA account to help to pay tax. Total reductions of account value or distributions is $201,000. Okay, so that’s how much we had to take out of the account, now we want to look at the tax schedule, same thing, age 75, year 2032. Top line is AGI, Adjusted Gross Income, $141,000. This is provisional income [unintelligible 00:15:49], this is used to help calculate Social Security taxation.

Here’s what I really want to focus on. We’re receiving, from the last page, I believe it was $79,000 of income from Social Security, but here, because of Social Security’s special tax privileges between 0% to 85% and there are tiers and thresholds and the provisional income calculation, which only takes into account 50% of your Social Security, the taxable amount of Social Security is only $59,000, so we’re getting closer to that 85% threshold of Social Security that could be taxed.

Now, why? Because we didn’t do any planning earlier in retirement. We kicked the can down the road, we’re forced to take all these required minimum distributions, and now these RMDs are creating add-ons where it’s bringing more and more Social Security into the picture. Something else to keep in mind here, if we look at modified adjusted gross income, $141,000, so at this point, we’re not quite into the territory where it causes extra taxation of your Medicare premiums, but it eventually will get there, and depending on your personal situation, this could happen much sooner.

Just a couple of other items here to point out before we look at the more strategic approach. Here we have, down here, your effective marginal rate. If you need to take one more dollar out of your account, it’s going to cost you 25%. That is the effective marginal rate. If you want to go on a vacation or if you want to give money to children or if you want to take money out for whatever reason, buy a car, it’s going to cost you 25% Uncle Sam gets of that distribution.

Now, over here, we look at the average rate, when we’re looking at the total taxes by all the income, we have an average rate of about 17%. Okay, so I wanted to show you from the base strategy what that looks like in the future. Now I want to compare it to what we would consider a more strategic approach that’s going to help pay less tax over time.

First, we look at the amount of Roth conversion. We see down here, 2026, that is an important date because the current tax code expires at the end of 2025, and we have a new tax code in 2026, so we have to take that into account whenever we’re doing this analysis because it is a significant change to the tax code. The rates don’t change too much, but it’s the brackets that are going to compress. As a rough estimate, you could have around $350,000 of income right now, and you’re not out of the 24% bracket if you’re married filing jointly, but that is going to be cut in half to around $175,000 in 2026.

Now, that was the 2017 brackets, they do adjust upwards for inflation, so it’ll probably be a bit higher than that, but the point is you have this massive opportunity to take advantage of the range of the tax bracket, and they are pretty much going to be cut in half in 2026. This particular approach calls for taking advantage of the current tax code. We see here the amount of Roth conversions and then a smaller one because this is what is most optimal at today’s point in time.

Now, when we do this analysis with you next year, it’s probably going to adjust a little bit because the balances in your account will be different, you’ll spend a different amount than what we’re projecting here. Everything is a little bit different, so it needs to be looked at every year. Now, something to point out here, a lot of times when people come to talk to us, they say, “Troy, well, I need to get everything converted.”

No, oftentimes you don’t have to get everything converted because when we start to extrapolate out these numbers over time and we take into consideration the actual tax code, when we’re taking Social Security, what your RMDs are going to be, the potential different amounts for Roth conversions, and the timings around the change in the tax code, often what we see is we can leave a certain balance inside the IRA to where the required minimum distribution on that account doesn’t cause massive Social Security taxation, no additional add-ons and also because we’ve done these Roth conversions, we can be in a situation to where we can have $100,000, $150,000, even $200,000 of income and pay very, very, very minimal taxes.

It’s just finding a balance, it’s finding an equilibrium point to where the cost of the conversion with respect to the add-ons and the potential reductions in the future compared to not doing it and what the cost of withdrawals in the future will be when you add back in those add-ons and potential reductions. I just want to point this out that– Husband and wife in this scenario have an IRA, one of them is being fully converted. Her IRA is the blue one.

We’re doing some conversions there but then we stop because we’ve kind of found that point of equilibrium where the required minimum distribution combined with Social Security and their other withdrawals meet their income needs but also puts them into a situation to where the taxes they’re paying are very, very minimal or advantageous to the overall plan with respect to the other potential decisions we could make. Non-IRA is the gold, the Roth is purple, and the Roth is over here.

Briefly want to show you what the withdrawal plan would look like. We’re taking this amount from the non-IRA accounts. We’re taking this amount from the IRAs, these are conversions, these are withdrawals. Then we’re supplementing all that income with distributions from the Roth IRA. As of today, this is the most optimal given the circumstances that we’ve looked at but guess what’s going to happen next year? It’s going to change not drastically usually but absolutely does change, and if we want to stay on top of this, we want to try to be as accurate as possible.

Okay. Now we want to look at the comparison. We have the funding sources chart here where we have $95,000 coming from Social Security at age 75. This is your required minimum distributions here, so only $25,000 of required minimum distributions. If we go over to the tax schedule, age 75, modified adjusted gross income is $57,000. The one cool thing– Well, there’s many cool things, but when it comes to Roth IRA account distributions, the tax-free income does not get added back into the modified adjusted gross income calculation.

Whereas municipal bonds, if we use muni bonds for tax-free income, that interest income does get added back into the calculation for modified adjusted gross income and can create some additional add-ons for various items. We have all the spending that we need, our Social Security or guaranteed lifetime income is significantly higher with this situation, and when we look at the taxable amount of our Social Security, $31,489 is the taxable portion of our almost $100,000 Social Security, so now because of what we’ve done earlier, we’re seeing those reductions that I mentioned.

We’re having the income that we need, but we’re not bringing Social Security into the picture, we’ve actually reduced the amount of Social Security income that is subject to taxation. Now, we start to look at the Tier 1 and Tier 2 for the thresholds of Social Security taxation, we have, if you guys are familiar with these, it’s 32,044, this is very important for determining what we will call a phase-in of Social Security taxation.

Long story short, it’s advantageous because it creates less taxation of our Social Security and this is how we get to the total taxes due of $4,218. Meanwhile we have $100,000 of Social Security, $25,000 of required minimum distributions plus we’re taking income to help for our lifestyle, our standard of living from the Roth IRA, and we’re only paying $4,000 in taxes. The two scenarios we compared there, one doing nothing creates additional add-ons later in life because of those forced RMDs and Social Security combined creating more and more of your Social Security to be taxed.

Whereas in the optimal strategy, we deferred Social Security, we did Roth conversions so we didn’t increase the cost of conversions by having add-ons in the beginning years, but what we did is we created reductions in the out years in regards to not bringing Social Security into the picture for taxation and we’re able to have the income that we want. We also didn’t have to convert all the IRAs, we left an amount there that was equal to a required minimum distribution estimated to be needed to maintain the living standards and also a very acceptable tax liability.

You’ve made it this far, thank you very much, because this was a more advanced and in-depth case study of income planning and tax planning and retirement and the different decisions that we can make and how they all come together to create a more optimal retirement plan for you. If you are a client, we’re doing this for you, you don’t have to worry about reaching out to us and asking if we’re doing this for you.

If you’re trying to do this yourself or you’re working with an advisor and you don’t feel you’re receiving this level of planning that it could benefit you, we’re here, feel free to reach out and give us a call. If you want, and we would appreciate this, share the video with a friend or family member because we’re trying to help people understand the complexities that go into making decisions and planning when it comes to retirement.