A Roth conversion can affect the premium you pay for Medicare Part B (the part that provides medical insurance, as opposed to hospital insurance or prescription drug coverage). For the year of the conversion it increases your income, potentially leading to an increase in your premium. On the other hand, in later years when you’re withdrawing money from your retirement account, your income will be smaller as a result of having done the conversion in a prior year, potentially allowing you to pay a smaller premium for many years. The net benefit or detriment will depend on individual circumstances.
Detriment for year of conversion
You don’t have to worry about incurring a higher premium if your conversion income is reported on a tax return for a year more than two years prior to your first year in the Medicare Part B program. If you aren’t currently in the program, and won’t be in the program for several years, you won’t incur higher premiums as a result of the conversion when you eventually enroll. (For an explanation of the Part B premium and income levels where it changes, see Medicare Part B Premium.)
Two-year spread. Note that you’re allowed to report income from a 2010 conversion on your tax returns for 2011 and 2012. This opportunity may help or hurt in connection with your Part B premium. Depending on your income level and the size of your Roth conversion, dividing the income between two years may prevent it from being big enough in either year to cause an increase in your premium. On the other hand, you may be in a position where reporting the income on your 2010 tax return avoids any impact (perhaps because you plan to enroll in the program in 2013), or results in a smaller overall impact because it affects only one year. In this case you may choose to report the income on your 2010 income tax return.
Cliff effect. Changes in the Medicare Part B premium occur in steps, creating a cliff effect. Filing single with $107,000 of income, for example, you would pay $154.70 per month — but if your tax return shows $107,001, your premium goes to the next level, which is $221.00. Multiplied by twelve for the year this premium would be in effect, the difference would be nearly $800 of additional premiums paid as a result of having just $1 of additional income.
Fortunately, the rules for Roth conversions make it possible to avoid this situation. You’re allowed to do a partial conversion, so you can try to calibrate the amount to keep your income just below the level that will move you into a higher premium category. Furthermore, you’re allowed to to a partial recharacterization, undoing part of a conversion. When you prepare your tax return for the year of the conversion you may find that your income is just a few dollars over where it needs to be. You can solve the problem by moving a small amount from the Roth back to a traditional IRA.
Benefit in later years
Income from IRA withdrawals counts in determining your Medicare Part B premium, but tax-free withdrawals from a Roth account won’t affect the premium. If your IRA withdrawals, together with other income, are pushing you into a higher premium category, a Roth conversion can produce significant savings. You may end up with a net benefit even if you incur a higher premium for the year of the conversion, because the lower premium you pay as a result of eliminating IRA distribution income from your tax return in the future can produce a benefit year after year, for as long as you participate in the Medicare Part B program.
Planning for this issue is highly individualized. It depends on your age, filing status, income level and size of your retirement account, among other factors. Generally, if it appears that a Roth conversion may be beneficial prior to taking the Medicare Part B premium into account, the potential for a negative effect isn’t likely to turn that strategy into a loser, although it may make sense to reduce the conversion amount to avoid the cliff effect described above. On the other hand, because of the potential to produce savings over a period of many years, people who can move to a lower Part B premium category by using a Roth conversion to reduce the amount of income they report from retirement plan distributions may find that the effect makes the Roth conversion strategy more attractive.