Roth Conversion Considerations

Written By: Ryan Rink, CFP®, EA, ChFC®, CLTC®

A common question we get from clients is if (and when) a Roth conversion makes sense. The answer is more complex than you may think, as there are a variety of considerations that play into the decision.

We’ll start by defining a Roth conversion. Simply put, a Roth conversion is moving funds from a pre-tax retirement account (such as 401(k) or traditional IRA) to an after-tax retirement account (Roth IRA or Roth 401(k)). The general logic behind completing a conversion is to pay the taxes now, but at a lower rate than you otherwise would later in retirement. The Roth account then grows tax-free, and no tax is owed on future distributions. Future tax brackets, Social Security and Medicare IRMAA (Income-Related Monthly Adjustment Amount) all need to be considered in determining if a Roth conversion is plausible.

Future Tax Bracket

If you are currently in a lower tax bracket than you anticipate to be in the future, then it is worth considering a Roth conversion. Generally speaking, we tend to see Roth conversions make the most sense for clients who are currently in the 10%, 12% or 22% marginal federal tax brackets. However, this really depends on your specific situation. Most clients tend to be in their lowest tax bracket just after retiring. At that point, they have no additional income from their job and likely have not started Social Security.

Once you begin your Required Minimum Distributions (RMDs) (age 73 or 75, depending on the year you were born), your income can increase dramatically, thus pushing you into a higher tax bracket. By doing a Roth conversion before your RMD start date, you can lower your RMDs later on, thus lowering future income in a higher tax bracket.

Example: Ryan and Bri just retired at age 62, have no pensions or deferred compensation income, and have not yet started Social Security. They anticipate an additional $150,000 of income once they begin taking their RMDs at age 75. They are good candidates for a Roth conversion since they could convert some of their pre-tax monies now and pay 12% federal tax instead of 22%+ later on. 

Social Security

If you or your spouse are currently drawing Social Security, it’s important to be aware that a Roth conversion could increase the taxability of your Social Security.

The taxation of your Social Security benefits is determined by the amount of your provisional income (also referred to as combined income). Provisional income is calculated by adding together your Adjusted Gross Income (AGI), tax-exempt interest and half of your Social Security benefits. For many of our clients, 85% of their benefit is subject to income tax. However, the taxable amount can be even lower if your provisional income is below certain thresholds (see below):

– 0% for those individuals who have provisional income below $25,000 ($32,000 for joint filers).

– Up to 50% for individuals who have provisional income above $25,000 but below $34,000 ($32,000 to $44,000 for joint filers).

– Up to 85% for individuals who have provisional income above $34,000 ($44,000 for joint filers).

A Roth conversion adds to your provisional income, which in turn can increase the taxable amount of your Social Security.

Example: Ryan and Bri just retired at age 62, have no pensions or deferred compensation income, and both decided to start drawing Social Security. Since they are in a low federal tax bracket, they think it is a good idea to do a $100,000 Roth conversion. However, by now completing that $100,000 conversion, they inadvertently just increased the taxability of their Social Security from 0% to 85%, meaning they will now owe income tax on 85% of their Social Security. The effective rate of their conversion is now higher than the 12% they originally intended. Therefore, a Roth conversion may have not been in their best interest. 

Medicare IRMAA

Completing a Roth conversion could impact IRMAA, which takes effect once you are on Medicare. Once your Modified Adjusted Gross Income (MAGI) reaches a certain level, your Medicare Part B and D premiums start to increase. For 2023, the increases begin at MAGI of $97,000 for single filers and $194,000 for married filing joint filers. The amount you convert in the current year is included in your taxable income, which means that your MAGI will increase. This may potentially push you into a higher income tax bracket and trigger IRMAA surcharges.

Keep in mind that IRMAA is based on your MAGI from two years prior. For example, 2023 IRMAA premiums are based off your 2021 MAGI. Therefore, if you complete a Roth conversion this year (2023), it won’t impact your IRMAA until two years from now (2025).

Read our Shakespeare blog, How Income Impacts Medicare Premiums, for additional specifics on IRMAA.

Example: Ryan just retired at age 64 and has a $25,000 pension. He is not on Medicare since he isn’t 65. He anticipates his income to jump by over $100,000 once he begins taking RMDs at age 75, so he decides to complete an $85,000 Roth conversion this year (2023). In 2025 (when he is 66 and on Medicare), he gets a notice that his Medicare Part B and D premiums are higher than the standard rates since he had high income in 2023 (two years prior). He now owes an additional $66/month for Medicare Part B and $12/month for Medicare Part D. This doesn’t necessarily negate the Roth conversion, however, it is something to be aware of.

Summary

As you can see, there are a lot of factors that go into analyzing if a Roth conversion makes sense. We often find the best times to consider Roth conversions are shortly after retiring, before drawing Social Security and before starting your Required Minimum Distributions (RMDs). It’s important to work with a qualified financial advisor and accountant to determine if a Roth conversion is in your best interest.

If you have questions regarding Roth conversions in your specific situation, feel free to reach out to your Shakespeare Financial Advisor at 262-814-1600.