Q&A: Side effects of IRA conversions

Dear Liz: I thought your readers would benefit from additional knowledge about Roth conversions. I started converting our IRAs to Roth IRAs when my wife and I turned 60 years old. Years later, I realized that our premiums for Medicare Part B and D were higher because our income in those years exceeded $174,000.

Answer: Triggering Medicare’s income-related monthly adjustment amount (IRMAA) is just one of the potential side effects of a later-in-life Roth conversion.

That’s not to say these conversions are a bad idea.

People with substantial amounts in traditional retirement accounts might benefit from transferring some of that money to Roth IRAs, particularly if the required minimum withdrawals that start at age 72 would push them into a higher tax bracket. They may have a window after they retire, when their tax bracket dips, to convert money and pay the tax bill at a lower rate.

Roths also don’t have the required minimum distributions that apply to other retirement accounts, so people have more control over their future tax bills.

Converting too much, however, can push people into higher tax brackets. Many financial advisors suggest their clients convert just enough to “fill out” their current bracket.

For example, the 12% bracket for married people filing jointly was $19,401 to $78,950 in 2019. A couple with income in the $50,000 range might convert $28,000 or so, because a larger conversion would push them into the 22% tax bracket.

But there are other considerations, as you discovered.

People with modified adjusted incomes above certain levels pay IRMAA adjustments that can add $144.60 to $491.60 each month to their Medicare Part B premiums for doctor visits and $12.20 to $76.40 to their monthly Part D drug coverage premiums. Higher income could reduce or eliminate tax breaks that are subject to income phaseouts, and conversions can subject more of your Social Security benefits to taxation.

At the very least, you should consult a tax pro before any Roth conversions to make sure you understand the ramifications. Ideally, you’d also be talking with a fee-only, fiduciary financial planner to make sure conversions, and your retirement plan in general, make sense.

Q&A: IRA conversions and taxes

Dear Liz: You recently advised a reader that if their income was too high to contribute to a Roth IRA, they could still contribute to an IRA or any after-tax options in their 401(k). You didn’t mention a two-step Roth IRA — first making a nondeductible contribution to an IRA and then immediately converting that amount to a Roth. That way those people whose income is too high to contribute to a direct Roth IRA can still have a Roth IRA using the two-step process.

Answer: This is known as a backdoor Roth contribution, which takes advantage of the fact that the income limits that apply to Roth contributions don’t apply to Roth conversions. Conversions, however, typically incur tax bills and don’t make sense for everyone. If you have a substantial amount of pretax money in IRAs, the tax bill can be considerable. (The tax bill is figured using all your IRAs, by the way. You can’t get around it just by contributing to a separate IRA that you then convert.)

Incurring that tax bill could make sense if you expect to be in the same tax bracket in retirement, or in a higher one. If you’re young and a good saver, it’s a good bet that will be the case. Roth conversions also can be advisable later in life if your tax bracket could jump when you reach age 72 and have to start taking required minimum distributions from your retirement accounts.

If you expect to be in a lower tax bracket in retirement, however, you probably should forgo Roth conversions because you’ll pay more now in taxes than you would later.

Of course, if you have little or no pretax money in your IRA, then backdoor conversions get a lot more attractive because the tax bill would be minimal. Otherwise, you should seek out a Roth conversion calculator to get a better idea of whether a conversion might be the right choice.

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