Roth conversions can boost Medicare premiums

But one year of higher health care costs may be worth it to lower RMDs and taxes in the future

By Mary Beth Franklin

Jun 14, 2018 @ 6:15 pm EST

The Tax Cut and Jobs Act of 2017 created generally lower tax rates for 2018 through 2025, presenting an enticing opportunity to convert traditional retirement savings to Roth accounts at today's lower rates. Under current law, individual income tax rates will revert to the higher 2017 levels, plus inflation adjustments, in 2026.

The prospect of creating future tax-free income through aggressive Roth conversions is undoubtedly attractive. But depending on a client's age and income, this year's Roth conversions could trigger higher Medicare premiums in 2020. (Medicare premiums are based on the latest available tax returns, generally two calendar years in arrears.)

Still, a temporary boost in health care costs may be a viable trade-off to reduce future annual required minimum distributions, trim income taxes and lower Medicare premiums over the long term.

Tax Changes

In 2017, the top of the 25% tax bracket for married couples filing jointly was $153,100. In 2018, the top of the new 24% bracket for married couples is more than double that amount at $315,000.

"You could convert double the amount of traditional retirement savings to a Roth this year as you could in 2017 at approximately the same tax rate," said William Meyer, founder and CEO of Social Security Solutions.

But for clients who are in or near retirement, income tax rates are just one piece of a complicated decision. Various thresholds for taxing Social Security benefits and triggering higher Medicare premiums add another layer of complexity. A change in one area can impact all the areas.

"Because the tax brackets have been increased, there is more opportunity to coordinate a tax-efficient withdrawal strategy before RMDs kick in at age 70½," Mr. Meyer said.

"While a Roth conversion is a great opportunity, it is easy to torpedo clients," he warned. "You could easily be fired or sued for not doing this extra analysis."

Mr. Meyer suggests that financial advisers first estimate the impact of a Roth conversion on the client's tax bracket and then calculate the impact on "provisional income," which determines what portion of Social Security benefits are taxable. Taxes are due on the entire converted amount, boosting a client's adjusted gross income for the year.

Provisional income is the sum of AGI plus half of Social Security benefits plus tax-exempt interest. Provisional income above $25,000 for singles and $32,000 for married couples means a portion of Social Security benefits — up to 85%— are taxable at ordinary income tax rates, which in turn can substantially increase the marginal tax rate.

For example, $100 of extra income withdrawn from an IRA can cause another $85 of Social Security benefits to be taxed, boosting taxable income by $185. For someone in the 22% tax bracket today, that additional $100 distribution from a taxable retirement account increases the marginal tax rate to 40.7% (22% x 1.85).

Mr. Meyer offered the example of a 67-year-old widow whom his company is advising through its Income Strategy software. The technology for consumers and financial advisers focuses on the interplay of detailed decisions that makes retirement planning challenging, including how different types of income impact income taxes, Social Security benefits and Medicare premiums.

"By aggressively converting funds to a Roth account to take full advantage of the 22% bracket (which tops out at $165,000) before turning 70½, she will be able to reduce funds in her tax-deferred IRA and thus reduce if not eliminate, the size of her RMDs subject to the 40.7% or higher marginal tax rates," Mr. Meyer explained. Smaller RMDs will shrink the amount of taxable income used to determine how much of her Social Security benefits will be taxed in the future.

Finally, advisers should do a separate calculation to determine modified adjusted gross income, which consists of AGI plus tax-exempt interest, Mr. Meyer said. MAGIs above $85,000 for individuals, and $170,000 for married couples filing jointly, trigger higher Medicare premiums, known as income-related monthly adjustment amounts, or IRMAA.

Medicare Part B premiums, which cover doctors' fees and outpatient services, range from a standard $134 per month per person in 2018 to as much as $428.60 per month per person, depending on income. Medicare Part D prescription drug plan premiums are also subject to high-income surcharges,

Converting a traditional IRA to a Roth IRA this year could also reduce the widow's future Medicare premiums. Beginning one year after the death of her husband, she will have to file taxes as a single individual with a lower standard deduction and a lower threshold for Medicare surcharges that start at $85,001 — half the level that applies to married couples and qualifying widows.

Smaller RMDs and tax-free distributions from her Roth IRA will hold the line on income taxes, the amount of Social Security benefits subject to taxes and Medicare premiums in the future.

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