Tax Considerations for Roth IRA Conversions
Roth conversions have become a popular topic of conversation, and for good reason. Converting money from a Traditional IRA to a Roth IRA can be a valuable long-term planning strategy, potentially reducing future Required Minimum Distributions (RMDs) and allowing future growth and withdrawals to be tax-free.
However, a Roth conversion isn’t automatically the right move for everyone. We never want the “tax tail to wag the dog,” so it’s important to look at the bigger picture before deciding whether a conversion makes sense for you.
Here are a few tax-related considerations to keep in mind:
- Could it increase your Medicare premiums?
If you’re already enrolled in Medicare, a Roth conversion increases your Modified Adjusted Gross Income (MAGI), which could cause you to pay higher Medicare Part B and Part D premiums through the Income-Related Monthly Adjustment Amount (IRMAA). IRMAA is based on your income from two years prior and the income thresholds are structured in brackets, so crossing into a higher bracket can result in a significant increase in your Medicare premiums. This means the tax cost of a Roth conversion isn’t necessarily limited to the income tax you pay on the conversion. For someone on Medicare, it’s important to consider the potential additional Medicare premiums as part of the overall cost. Learn more about Medicare costs and IRMAA.
- Could it affect your ACA health insurance subsidies?
If you retire before Medicare eligibility and purchase health insurance through the Affordable Care Act (ACA) Marketplace, your income can affect the amount of premium tax credit you receive.
A Roth conversion generally counts toward the income used to determine your ACA subsidy. As a result, a large conversion could reduce your subsidy—or potentially eliminate it altogether, depending on your circumstances.
For early retirees, this can be a significant consideration. The additional income tax from the conversion may be only part of the equation; losing some or all of your health insurance subsidy could add substantially to the cost.
- How will you pay the taxes?
It’s important to consider where the money for the tax bill will come from.
Ideally, you have cash or other non-retirement assets available to pay the taxes generated by the conversion. If you instead withhold money from the IRA to pay the taxes, you’ll have less money actually making its way into the Roth IRA.
- What tax bracket will the conversion put you in?
A Roth conversion is taxable as ordinary income which means the amount you convert can push some of your income into a higher marginal federal and/or state income tax bracket. This doesn’t necessarily mean a conversion is a bad idea. The key question is whether paying taxes on the money today makes sense compared with the taxes you or your heirs may pay if the money remains in a Traditional IRA. Rather than simply asking, “Should I do a Roth conversion?” it can be more useful to ask, “How much should I convert this year?” A partial conversion that fills a particular tax bracket may make more sense than converting a large amount all at once.
- Could the conversion affect other tax benefits or deductions?
Because a Roth conversion increases your taxable income, it can affect more than just your marginal tax rate. Depending on your circumstances, higher income could also affect items such as the taxation of Social Security benefits, certain deductions or credits, and other income-based benefits.
This is one reason Roth conversions are best evaluated as part of your overall tax plan rather than in isolation.
Roth conversions can be a powerful retirement planning tool. They may help reduce future RMDs, provide greater flexibility over where your retirement income comes from, and allow future growth and qualified withdrawals to be tax-free. But the decision isn’t simply about whether you want more money in a Roth IRA. It’s about when and how much to convert, and what the conversion will cost you today compared with the potential tax benefits in the future.
Other Resources:
Basics of a Roth IRA Conversion
Is there Room Left in Your Tax Bracket?
Basics of a Roth IRA Conversionhttps://www.mainstreetplanning.com/posts/basics-of-a-roth-ira-conversion/
