I have long touted the benefits of diversifying a client’s assets when creating and implementing a retirement income plan. Having the ability to draw down assets that carry varying tax characteristics (e.g., if the assets are taxed as ordinary or capital gain income, are tax exempt or are tax free) allows the client an income stream while mitigating the tax impact of that income.
When solely taking distributions from pretax retirement vehicles, a client is subject to ordinary income, which is taxed at his or her marginal tax rate. One strategy that many advisors recommend, and for good planning reasons, is a Roth conversion. In low-income years in particular, it can help clients move toward tax diversification. But before you decide to recommend a conversion to a client who is in or near retirement, you need to be aware of a potential side effect.
How Roth Conversions, and an Overlooked Consequence
A Roth conversion is a relatively easy strategy to understand and implement. An IRA owner can convert all or a portion of a traditional IRA to a Roth IRA by submitting a short and simple form to the IRA custodian. The amount converted is taxable as ordinary income in the year of conversion. Assuming that the requirements of the 5fiveyear rule are met, the funds in the Roth IRA will be tax free upon distribution. Seems rather simple, right?
Although converting to a Roth IRA may be a very smart move for the right client, I have often found that advisors miss one unintended consequence of this decision when working with clients who are nearing retirement. The client is certainly likely to anticipate the tax consequences of the conversion, but he or she seldom expects that the higher income brought about by the conversion can lead to an increase in his or her Medicare Part B monthly premiums.
Why the Increase in Medicare Part B Premiums?
Medicare Part B covers services considered medically necessary to treat a disease or condition, including doctors’ services, outpatient care, some home health care, and more. Premiums for Part B vary, based on the insured’s Medicare income. If the insured’s income, which includes adjusted gross and tax-exempt monies, exceeds certain thresholds, his or her monthly Part B premiums can rise significantly.
In 2015, the income threshold to qualify for paying only the standard Medicare Part B premium of $104.90 per month is $85,000 or less. Individuals earning $214,000 or more pay the highest premium amount of $335.70 per month.
Here’s an example. Let’s say that your client’s annual adjusted gross income (AGI) is typically below $85,000. This year, however, he converts a traditional IRA to a Roth, and the amount of the conversion—$130,000—will be added to his income. If his AGI for 2015 increases to around $215,000, surpassing the highest Medicare annual AGI threshold, your client’s Part B premium will rise to $335.70 per month . . . but not right away.
A Rate Increase That Shows Up Almost Two Years Later!
Even more disagreeable to your client than the unanticipated premium increase is the fact that he won’t find out about the impact of his higher income for 2015 until two years later!
Here’s another example. When a Roth conversion occurs in 2015, your client will report the conversion on a tax return filed in 2016. Sometime thereafter, the Social Security Administration will be notified about the increased income and recalculate your client’s Part B premium for fiscal 2017. It’s in late 2016, when the premium rates are announced for the following year, that your client will learn that his monthly Part B premiums will skyrocket in 2017 because of his increased income in 2015.
And the Moral of the Story?
Please be mindful of the unintended consequences that can result when you suggest that a client who is in or near retirement consider a Roth conversion. Tax diversification can have a positive impact upon a retiree’s income plan but not at the cost of soaring Medicare Part B premiums. No doubt you would hate to be the advisor who recommended a $130,000 conversion to a client only to hear two years later that your advice caused the client’s insurance premiums to go up $230.80 a month!