What You Need to Know
- Welcome to Connecting the Dots, the column where Marcia Mantell discusses real-life decisions around Social Security claiming and retirement.
- A closer look at this client's plan shows she may get hit with unexpected taxes and surcharges.
- Understanding how MAGI, Medicare and Social Security come together is key to getting the most benefit from a Roth conversion.
Few in 1997 would have predicted how popular Roth conversions would become as an estate planning strategy. No one imagined we’d be talking about “backdoor Roth” conversions. And connecting the dots between a Roth conversion and Medicare and Social Security was on no one’s radar.
Yet, as the Roth turns 25 during a jittery market, conversations about the value of Roth conversions are popping up more often than ever before.
As clients near retirement, they come face-to-face with significant future tax obligations stemming from substantial tax-deferred assets. Converting some IRA and 401(k) assets is a strategy to consider.
But too often, financial advisors only consider tax-bracket creep. In today’s more complex retirement system, that is not sufficient.
Understanding where Roth conversions, modified adjusted gross income (MAGI), Medicare and Social Security all tangle together is a necessary part of any complete analysis.
An Example With Three Options
As Lynne nears retirement, she’s focused on reducing expected taxes throughout retirement and leaving a sizable gift to her alma mater. As a single woman, she also needs to maintain flexibility with her accounts. Her financial advisor suggested converting her $400,000 traditional IRA to a Roth IRA.
She could convert all at once, split it over two years, or over four years. They discussed tax considerations of each choice.
Option 1: Rip Off the Band-Aid
Earning $100,000 today puts Lynne in the 24% tax bracket for single filers. Since the value of her IRA is down with the recent market declines, she could convert in one transaction. Her tax rate would jump to the 35% rate. But the sting will be short-lived.
Option 2: 50/50 Conversion
Rather than taking the full tax hit this year, she can convert $200,000 this year and next year. This still pushes her into the 35% tax bracket, but the check she has to write is a lot smaller. This helps manage cash flow and flexibility.