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.
Conclusions
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.
Related
Tags: Roth conversion
I didn’t realize “you’re allowed to to a partial recharacterization, undoing part of a conversion.” According to your statement, this means you are allowed to do a partial (or full) conversion and then recharacterized ANY portion of the partial (or full) conversion amount ($150.00, $1500.00, etc.) within the deadline? I know you can do a partial conversion, but thought if you wanted to recharacterize, it would be ALL or NOTHING.
No, it’s not all or nothing. See the instructions for Form 8606 (page 3, column 2) (PDF) where the IRS talks about partial recharacterizations.
People sometimes ask if you can contribute to TIRA/Roth IRA if you do not have earned income. The answer is of course no. However, because Roth is “bigger” than TIRA, when you do a Roth conversion, it is as if you are making an additional IRA contribution (about equal to the amount of income tax you pay).
If your income tax rate is at 25% at conversion and at distribution later if you did not convert, and you convert $40000. You would pay $10000 in income tax now, but your $10000 really went to make your IRA bigger (by $10000).
Is my thinking correct?
This is an important point that’s often overlooked. If you have money outside your retirement account that can be used to pay the tax on the conversion, you’re effectively increasing the amount of money sheltered from income tax. This is why it’s possible in some cases to come out ahead with a conversion strategy even if the tax rate you pay on the conversion is higher than your anticipated tax rate on withdrawals if you don’t convert. We’ve talked about the concept that a Roth IRA is effectively bigger than a traditional IRA repeatedly, including here, here and here.
How would a Value Added Tax affect the Roth, assuming that the VAT is not replacing normal income tax, but just an additional tax?
We’re a long way from building the kind of political consensus that would be needed to impose a value added tax, but some serious minds believe we may be heading in that direction, if only because circumstances may force us into it. For background, a good discussion of the topic appears in this MoneyWatch article. I’ll note that I remember Lester Thurow predicting that a VAT was likely in our future, some 25 years ago, so I’m not yet ready to hold my breath waiting for it.
To respond to the specific question, a VAT would affect a Roth and a traditional retirement account the same way. It wouldn’t change the treatment of distributions from the account, but it would increase the cost of goods purchased with those distributions, in much the same way a national sales tax would. I don’t believe there’s any direct impact on Roth planning. Indirectly, however, a VAT might reduce the benefits of a Roth in comparison with a traditional IRA, partly because it would relieve pressure to impose higher rates of income tax, and partly because the resulting higher cost of goods would cause people to draw down their retirement accounts faster, diminishing the Roth’s long-term benefits.