Your Social Security may be taxed at retirement. You might find this to be outrageous, but it's true. If your income exceeds a certain threshold during retirement, the taxes you paid to fund your Social Security income may be taxed when you receive the benefit payment. Those thresholds may be exceeded if you receive a pension.
Social Security is insurance you receive when you retire. This insurance is designed to provide a minimum level of income to you so that you don't retire without any money. A pension is either a government or private retirement plan that is funded by your employer. You receive monthly payments from the pension plan after you retire.
Your Social Security payments will be taxed if one-half of your Social Security income plus your pension income exceeds certain thresholds. Up to 50 percent of your Social Security income is taxable if your income is between $25,000 and $34,000 and you are filing single. Anything over $34,000 subjects 85 percent of your Social Security to ordinary income tax. If you're married, you are taxed on 50 percent of your Social Security benefits if you and your spouse's combined income is between $32,000 and $44,000. Anything over $44,000 subjects 85 percent of your Social Security benefits to taxation.
Converting your pension income to nontaxable income solves the problem of your Social Security income being taxed. You may take your pension income as a lump sum amount when you retire. You receive the total accumulated value of your pension, less interest that would be made on payments to you. You may then convert this amount to a Roth IRA. Roth IRAs are retirement accounts that eliminate taxation on future retirement benefits at retirement. Income from Roth IRAs is also excluded from the calculation to determine whether your Social Security income is subject to taxation.
You should keep in mind that you pay income tax on all money you convert to a Roth IRA. This is a one-time payment of tax. You may also be subject to income tax on your Social Security in the first year of receiving benefits if you convert your pension in the same year that you receive Social Security income.
- IRS: Pension and Annuity Income
- "Practicing Financial Planning for Professionals (Practitioners' Edition), 10th Edition"; Sid Mittra, et al.; 2007
- Social Security Administration: Taxes and Your Social Security Benefits