IRAs and Social Security: Fact or Fiction?
By Jeffery Levine, IRA Technical Expert
Follow Me on Twitter: @IRAGuru4EdSlott
Social Security has been a popular topic of conversation among current and soon-to-be retirees as well as Washington lawmakers as Congress tries to deal with a major deficit issue. Below we talk about some of the ties between IRAs and Social Security as well as some of the misconceptions.
1) Making deductible contributions to my IRA will reduce the amount of Social Security tax I have to pay on my salary.
FICTION: IRA contributions, both deductible and nondeductible, will not decrease your Social Security tax liability. While making deductible IRA contributions is a great way to reduce your ordinary income tax liability, the deduction won’t do anything to help you reduce the amount of Social Security tax you owe. Salary deferrals to 401(k)s and similar plans also will not reduce the amount of Social Security tax you’ll owe on your earnings. If you’re an employee, your employer automatically withholds this tax. If you’re self-employed, you must generally include the amount of Social Security tax you owe in your estimated tax payments. If you’re self-employed you should also note that certain contributions to a plan, like SEP contributions, don’t reduce your self-employment tax, which includes the tax for Social Security.
In 2013, the FICA, or Federal Insurance Contributions Act, Social Security tax is 6.2% (up from 4.2% in 2012) of your salary, up to $113,700 (up from $110,100 in 2012). That means that as an employee, you could be paying up to $7,049.40 in Social Security tax this year! If you are self employed it’s even worse. You pay twice that amount, or $14,098.80, on your first $113,700 of self-employment income. There is also a Medicare component of FICA, but that’s beyond the scope of this article.
2) If I begin receiving Social Security early (before my full retirement age), any IRA distributions I take could reduce the amount of Social Security I’m eligible to receive.
FICTION: IRA distributions do not impact the amount of your Social Security benefits. If you take Social Security before your full retirement age (66 for those born January 2, 1943 through January 1, 1955 and later for those born after) and are still working, your earned income could reduce the amount of your Social Security payments. For instance, if you are younger than your full retirement age throughout all of 2013 and are receiving Social Security benefits, your payments will be reduced by $1 for each $2 you earn above $15,120. Thankfully, IRA distributions don’t count as earned income so no matter how big of a distribution you take, your Social Security payments will be unaffected.
3) My required minimum distributions (RMDs) can increase the amount of tax I owe on my Social Security payments.
FACT: The amount of your Social Security benefits that are subject to income tax depends on how much “combined income” (a.k.a. “provisional income”) you have. The exact calculation of this income is a little complicated (check out IRS Publication 915 for more info), but suffice to say, when you are calculating this income, you must include distributions from IRAs. Even required minimum distributions that you don’t want or need, but have to take.
According to the Social Security website, paying taxes on your Social Security benefits “usually happens only if you have other substantial income (such as wages, self-employment, interest, dividends and other taxable income that must be reported on your tax return) in addition to your benefits.” Unfortunately, the Social Security administration’s definition of substantial is different than what you might call substantial. In fact, if you are married and file a joint return, you will be paying tax on your Social Security benefits if your “combined income” exceeds $32,000 – and that includes counting half of your Social Security benefits!
If your “combined income” is below that, you won’t owe any tax on your Social Security income. As your income begins to rise above it, up to 50% of your Social Security benefits will be subject to income tax and if your income rises even further, up to 85% of your Social Security benefits can become be taxable. So if your Social Security benefits are not currently 85% taxable and you take an IRA distribution like an RMD, you could very well find yourself paying more tax on your Social Security than in years past.
4) Making a Roth conversion will increase the amount of tax I owe on my Social Security income.
FACTION: We kind of needed to make up a hybrid word here because the statement above can be both true or false depending on a variety of factors such as when you make the Roth conversion, how much you convert and what your other income is. Let’s look at 3 brief examples to illustrate.
1) First, let’s suppose you make a Roth IRA conversion prior to taking Social Security benefits. Since you are not yet receiving any Social Security benefits, you have nothing to worry about. Plus, you will have no RMDs in later years, so you won’t be forced to take any of your retirement funds against your wishes, increasing the tax you would owe on Social Security benefits at that time.
2) Next, let’s suppose you are already taking Social Security benefits, but because you have enough other income, like interest and dividends, you are already paying tax on 85% of your Social Security benefits. Well folks, 85% is the maximum amount and you are already there. So no matter how much you convert, the amount of tax you will owe on your Social Security benefits can’t increase. Of course, your Roth conversion income will add to your tax bill and could push you into a higher tax bracket. Just as in our example above, once you convert you won’t be forced to take any of your Roth IRA retirement funds against your wishes, potentially reducing the amount of Social Security benefits subject to tax in future years.
3) Finally, let’s suppose that you are 68 years old and are currently receiving Social Security benefits, but, because your other income is low enough, none of it is subject to income tax. Well, if you make a significant enough Roth conversion, say $50,000 or so, you will already have enough income that 85% - the maximum amount – of your Social Security benefits will be taxable.
That might be a tough pill to swallow, but here’s a spoonful of sugar to help that medicine go down. Your Roth conversion will only cause you to pay more tax on your Social Security payments in the year you convert. If you don’t convert on the other hand, when you start taking RMDs in future years, your Social Security benefits could be affected each year.