Avoiding Nasty Surprises in Roth IRA Conversions: A Case Study

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.

Strategic Considerations

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.

Option 3: Dole Out the Savings in Four Parts

The other option is to convert $100,000 per year for the next four years. She’ll land in the 32% tax bracket each year. The asset value of the remaining IRA will fluctuate over the next three years, but overall, taxes owed could be meaningfully less.

At first glance, she prefers Option 3 to stretch out tax payments. But that’s not the full analysis.

Putting Social Security, Medicare Into the Mix

Lynne’s financial advisor needs to bring in additional information. Key to know is when she is planning to retire. Lynne is 62 this year, planning to retire at 65 if she keeps her job. When she retires, she’ll start Social Security and Medicare right away.

If she chooses option 3, it adds an extra $100,000 to her first year of retirement. That not only increases her tax bill overall, but also makes 85% of her Social Security benefit taxable.

Furthermore, she’ll be subject to IRMAA — Income-Related Monthly Adjustment Amounts — on her Medicare Part B and Part D premiums. That’s an additional monthly amount she’ll owe for having high income in retirement. 

If Lynne converted $100,000 to her Roth IRA each year between ages 62 and 65, she lands in the 32% tax bracket. Behind the scenes, her future Medicare Part B premium jumped from the base premium of $170.10 to $544.30 plus Part D premium of $71.30.

That’s an additional $5,346 she’ll owe for Medicare using 2022 premiums. (Medicare premiums are based on MAGI from two years earlier).  

The same IRMAA will also apply for two additional years as her age 67 Medicare premiums will be determined on her age 65 MAGI.

All Is Not Lost: Time to Appeal

Lynne can file form SSA-44 to request a recalculation of her Part B premium due to a qualifying life event (retirement). Lynne expects her income in retirement to be about $85,000, including Social Security. That puts her in the 22% tax bracket and keeps her in the standard Part B Medicare premium tier. Social Security benefits will still be taxable.

Converting to a Roth IRA can be an effective strategy, especially when a client has a specific purpose for the money. However, financial advisors need to connect all the dots of making this financial move by reviewing these issues: 

• Social Security becomes part of taxable income, but at what tax rate/? 
• Clients risk higher Part B and D premiums for one or more years. 
• Additional steps must be taken to file an appeal multiple years into retirement. 

Roth conversions can bring unwelcome surprises. Help clients avoid the hidden traps.

Marcia Mantell is the founder and president of Mantell Retirement Consulting, Inc., a retirement business development, marketing & communications, and education company supporting the financial services industry, advisors, and their clients. She is author of “What’s the Deal with Retirement Planning for Women/?,” “What’s the Deal with Social Security for Women?” and blogs at BoomerRetirementBriefs.com.