Want to Know More About A Not So Obvious Benefit of Roth IRAs?

Roth IRAs are one of the best retirement accumulation vehicles available because they offer tax-free accumulation, tax-free distributions, and no required minimum distributions. In addition, accessibility to the funds is hassle-free and withdrawals of contributions are always tax-free.

One Roth IRA income tax benefit is not talked about enough - the income tax effect of a Roth IRA on the taxation of Social Security benefits. When analyzing a client’s retirement income planning strategy, these benefits of Roth IRAs become more obvious. We can demonstrate the potential benefit of Roth IRA income for a retired couple in a simple example:

EXAMPLE 1

Bob and Betty are age 66 and retired. Their 2011 annual income is derived as follows:

Bob – A $30,000 withdrawal from a Traditional IRA, all taxable, and $15,000 of retirement income from Social Security

Betty – A $30,000 withdrawal from a Traditional IRA, all taxable, and $15,000 of retirement income from Social Security

They have no other income and take the standard deductions and exemptions. The income tax results of this scenario are as follows:

  • Total income tax: about $8,800.
  • Federal marginal tax bracket MFJ: 15%.
  • Effective rate of gross income = 9.8%.

EXAMPLE 2

Now let’s assume Betty’s IRA is a Roth IRA with the same income, standard deduction and exemptions.  The income tax results of this alternative scenario are different:

  • Total income tax: about $1,550
  • Federal marginal tax bracket MFJ: 10%
  • Effective rate of gross income = 1.8%.

What happened?

The gross income from the IRAs dropped by $30,000 in a 15% marginal bracket suggesting that the income taxes should drop by $4,500. But the taxes dropped by $7,250 as if in a 24% marginal bracket. Why? The amount of Social Security income that is taxed depends on the amount of the taxpayer’s Modified Adjusted Gross Income, or MAGI. The details are a little complex to explain here, but essentially when the taxpayer’s tax return is completed, an IRS “Social Security Benefits Worksheet” determines how much of the taxpayer’s Social Security income is subject to taxation. Generally, as a taxpayer’s income increases, a larger portion (up to 85%) of the Social Security income is included as taxable income. Certain types of income are not included in this calculation, including withdrawals from Roth IRAs. In our examples above, a summary of the income tax results is as follows:

EXAMPLE 1

EXAMPLE 2

Gross Receipts

$90,000

$90,000

Taxable Amount of IRA withdrawals

$60,000

$30,000

Taxable Amount of Social Security Benefits

$25,500

$  6,850

Total Income Tax Due

$  8,800

$  1,550

Effective Income Tax Rate

         9.8%

         1.8%

Gross Receipts Less Income Tax

$81,200

$88,450

Results will vary with each individual case. As the gross income increases, the effect of reducing the taxation of Social Security benefits vanishes. Nonetheless, when working on a retirement income analysis, the type of distribution can have a more substantial impact on taxation than may be first assumed and is a key consideration in retirement income planning.

To learn more about retirement planning please visit our website, www.greeneconsults.com, and take a look at our Retirement Specialist Program.

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