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December 15, 2013

Avoiding a Roth Conversion Tax Surprise

The first article in this series discussed the principal differences between traditional and Roth IRAs. Last week we identified both the benefits and tax consequences of converting a traditional IRA to a Roth IRA, both of which have important and long-lasting implications for an individual’s finances.

In general terms converting from a traditional IRA to a Roth IRA can be attractive for those who don’t expect a significant decline in their tax rate in retirement. Even for those who do however, if they have sufficient non-retirement assets with which to pay the conversion taxes and plan to defer IRA withdrawals longer than the required minimum distribution (RMD) rules for traditional IRAs permit, a Roth conversion can still be a smart move.

However, even for those for whom converting seems to make sense, it’s important to understand both the positive and negative ramifications resulting from the spike in income. Let’s look at three key areas that may be impacted by a Roth conversion.

1. Social Security and Medicare: The amount of Social Security benefits that are subject to tax and the rate at which those benefits are taxed are based upon an individual’s or married couple’s income level and tax bracket. Therefore, a jump in income resulting from a conversion can produce a double tax whammy by potentially increasing the portion of Social Security benefits subject to taxation and pushing the retiree into a higher bracket.

The impact on Medicare premiums is slightly different. For higher income retirees, Medicare Part B and Part D premiums are increased (sometimes significantly) above the standard premium that most seniors pay. The adjustments are based upon income tax returns two year’s prior. Therefore a Roth conversion completed in 2013 could affect an individual’s Medicare premiums for 2015.

The good news is that both the Social Security and Medicare repercussions are one year hits caused by conversion. After that the Roth IRA may actually help some higher income retirees save money because unlike traditional IRAs, distributions from a Roth do not increase taxable income. For many this should help to keep both taxes and Medicare premiums lower in the long run.

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