EagleTribune.com, North Andover, MA

December 15, 2013

Avoiding a Roth Conversion Tax Surprise

Financially Speaking
John Spoto

---- — 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.

2. The new 3.8 percent Medicare tax on investment income: To help offset the cost of the new health care law a 3.8 percent Medicare surtax on investment income (e.g. interest, dividends and capital gains) was introduced this year. It affects high income individuals and couples earning over $200,000 and $250,000 per year respectively. Although the income generated by a Roth conversion is not considered investment earnings, it can push a taxpayer over the income thresholds, subjecting more of their investment income to the 3.8 percent Medicare tax.

As with the impact on Social Security benefit taxation, once the initial tax blow is dealt, the fact that any Roth distributions will not increase taxable income, a conversion may offer a long-term tax saving opportunity for certain high earning investors.

3. College financial aid: Parents with college-bound children who expect to be eligible for financial aid need to be aware of the potential effect a Roth conversion may have on that assistance. Although many schools do not include the parent’s retirement assets in the financial aid assessment, parent’s income is a major factor in the formula. Generally speaking, including conversion income in the financial aid formula can hurt a family’s chances of securing assistance.

Despite the retirement, tax and estate planning opportunities a Roth conversion provides, many investors who could otherwise capitalize on them seem reluctant to do so. I suspect there are several factors at play, chief among them being an aversion to paying taxes earlier than necessary and a failure to fully understand the benefits a conversion offers.

For others the benefits offered by a Roth conversion come at too steep a price. In particular the acceleration of taxes and the impact on other areas of their finances simply make this a poor choice.

Financial planning is a highly personal process especially when taxes are involved. A smart decision for one person may be a poor one for another in a similar situation. In addition because of the complexity of our tax code a sensible decision in one area of our finances could have unintended consequences in another. This certainly applies to the Roth conversion decision.

Still inertia is not a strategy. Do your homework to determine if converting to a Roth makes sense for you. Before taking any action talk with your tax professional to ensure you are making the right decision and implementing it properly. The opportunity to materially preserve and improve your lifetime wealth and increase the chances of passing down a financial legacy to your heirs should provide sufficient motivation.

John Spoto is the founder of Sentry Financial Planning in Andover and Danvers. For more information, call 978-475-2533 or visit www.sentryfinancialplanning.com.

This article is for general information purposes only and is not intended to provide specific advice on individual financial, tax, or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions.