Should you consider a Roth conversion in retirement?

In this blog we talk about some of the benefits and risks associated with doing a Roth conversion in retirement, particularly how a Roth conversion can be used to effectively pass wealth to children & grandchildren. We’ll discuss why it may be a useful option to consider, as well as what the potential drawbacks may be.

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The “retiree state shift”

We commonly see retirees moving in their retirement years to states with more friendly taxes. We call this the “retiree state shift.”

The rationale makes sense. Many retirees have large nest eggs built primarily on tax-deferred savings vehicles like 401(k)s and Traditional IRAs. When they reach the age where Required Minimum Distributions (RMDs) hit, they’ll be paying the ordinary income tax rate on those withdrawals.

It’s a typical story. Nothing new here.

Here’s a twist.

Enter the children & grandkids!

Let’s say that you don’t plan on depleting your entire Traditional IRA balance. How do you pass your IRA assets on to your heirs in a tax efficient manner?

It’s very common that the retiree is living in a low tax state (Texas or Florida) while their children or grandchildren remain in high tax states like California or New York. Let’s suppose you are in a similar situation.

There are benefits to converting your Traditional IRA to a Roth IRA while in a low tax state for wealth transfer purposes:

• Inheritors receive a tax-free asset

• Future state taxes are avoided because the asset was converted in a no or low tax state

• Non-spouse inherited Roth IRAs can grow for 10 more years after death before being distributed (engendering 10 extra years of tax-free growth).

• RMDs are not required on Inherited Roth IRAs

Before we continue on with the blog, please remember that nothing in this article may be interpreted as advice specific to your situation. All concepts discussed here are general in nature, and nothing may be interpreted as a financial or tax recommendation of any sort. For such advice, consult with a financial advisor. 

Roth conversion during retirement: example

Should a retiree do a Roth conversion? Let’s look at an example.

Suppose there is a couple with a $1M IRA that will be passed to three children.

The couple moves from California (a high tax state) to Tennessee (a no tax state) in retirement. All three kids live in California, and two are not married.

The couple can convert a part of their Traditional IRA to Roth IRA each year while staying within the lower (22% and 24%) federal tax brackets, effectively avoiding California state taxes to the inheritor while also getting preferential Married Filing Jointly rates as opposed to Single or Head of Household rates.

Most people will earn less money in retirement than they are while working. Let’s say the couple is getting somewhere between $83,550 and $340,100 a year in income while retired, derived from sources such as Social Security, pensions, portfolio income, and RMDs.

Converting to Roth while retired, and hence likely falling into the 22% or 24% federal tax brackets, is a preferred rate to do a Roth conversion at, versus the higher 32% or 35% tax brackets.

If they were to convert at the 32% or higher tax bracket, the tax bill is high. At that “price” it may be equivalent or higher than the amount they would pay if they were subject to both federal and state taxes. There likely isn’t a benefit in terms of the overall tax cost.

The bottom line – they can split up their conversion across multiple years to realize tax savings and avoid the highest tax brackets.

Suppose their income were $100,000 from Social Security and pensions. They would be “allowed” to take up to another $240,000 (to hit $340,000 at the top of the 24% bracket) with this strategy.

How do Roth conversions affect Medicare premiums?

Retirees doing a Roth conversion should go about it carefully, considering the impact on Medicare premiums.

Realizing extra income in a given year may push you into higher Medicare brackets down the road. You have to figure out if doing a Roth conversion for multiple years is worth it. It may be better to do the Roth conversion all in one year because you can avoid paying higher Medicare premiums - even if you are paying higher taxes.

Here is a closer look at why Roth conversions made as a retiree must be done carefully. Many retirees are on Medicare, and Medicare Part B and Part D costs are tiered based upon Adjusted Gross Income (AGI) reported 2 years earlier.

 This chart from Medicare.gov displays the Part B monthly premiums:

 This chart displays the Part D monthly premiums:

A hypothetical example of the “Medicare Premium Tax”

 A Roth conversion may push your taxable income high enough to cause an income-adjusted surcharge in Medicare premiums.

 For example:

• A married couple with $100,000 of income would be paying the lowest Medicare rates of $170.10 (2022) for Part B and $0 for Part D.

• If they did a $200,000 Roth conversion and pushed themselves up to $300,000 of income, they would be paying $442.30 each for Part B and $51.70 for Part D.

• The difference in premiums is $322.90 more per month ($494 per spouse per month less the $170.10 that they would have paid) per spouse, or $7,749.60 of additional Medicare premiums owed on the conversion.

The $7,749.60 is 3.87% of $200,000 which can be thought of as a Medicare premium “tax”. The effective tax rate of the conversion would be the about 27% if you combine the 22%/24% for federal taxes (let’s assume it 23% on average) with an extra 3.87% for Medicare.

If this happens on a one-time basis (as opposed to every year), Clients can request a Medicare premium adjustment. There are no guarantees the adjustment will be granted and lower premiums reinstated, but it is possible.

Should a retiree do a Roth conversion?

When you combine the Medicare premium brackets and the Federal tax brackets, it may likely makes sense for a couple to convert up to a Modified Adjusted Gross Income (MAGI) of $180,000. This keeps a married filing jointly couple in the lowest Medicare bracket and in the 22% federal bracket. Above this MAGI level is when you need to figure out the marginal rate of federal and Medicare premium increase.

Is a Roth conversion right for you during your retirement? There are a number of factors to consider. If you have questions on this topic or others, we encourage you to please reach out.

CONTRIBUTOR

Andrew Hoffarth, CFP® is a Lead Advisor with Financial Alternatives. When he’s not enjoying outdoor activities with his family, he excels at finding solutions for complex financial situations, allowing successful families to focus on what is most important to them. Schedule a time to chat with Andrew.

Sources

Medicare.gov. Medicare costs at a glance. Retrieved from https://www.medicare.gov/your-medicare-costs/medicare-costs-at-a-glance

York, Erica. (2021, November 10th). 2022 Tax Brackets. Tax Foundation. Retrieved from https://taxfoundation.org/2022-tax-brackets/