Roth conversions have become a popular strategy for retirees, but they may not be the financial panacea they're often portrayed as. While the idea of tax-free growth in retirement is appealing, the reality for many retirees is a significant tax bill that can come as a surprise. In this article, I'll delve into why Roth conversions can backfire for most retirees and what you need to consider before making the leap.
The Tax Bill Nobody Plans For
Financial advisor Wes Moss, CFP, recently highlighted a critical aspect of Roth conversions that is often overlooked: the tax bill that follows. On the Clark Howard Podcast, Moss pointed out that while retirees are initially excited about the potential benefits of Roth conversions, they often forget about the $12,000 tax bill that comes due three to six months later. Howard, who is a big proponent of Roth conversions, admitted to having a bias towards the strategy, but also recognized the potential downsides.
The issue arises because the IRS treats Roth conversions as ordinary income, which means retirees have to pay taxes on the converted amount immediately. For a married couple in the 24% tax bracket, this can result in a substantial tax bill, especially if they convert a significant amount from their traditional IRA. Moss's example of converting $50,000 illustrates the point: the tax bill would be around $12,000, which could come from the IRA itself, shrinking the asset, or from a taxable brokerage account, potentially triggering capital gains.
The IRMAA Trap
One of the most insidious aspects of Roth conversions is the Income-Related Monthly Adjustment Amount (IRMAA) on Medicare premiums. Once retirees reach age 73 and start taking Required Minimum Distributions (RMDs), or if a large Roth conversion spikes their reported income, their Medicare Part B and Part D premiums can skyrocket. Moss noted that IRMAA is two years behind the actual income, making it difficult to plan for. This means that retirees may pay tax on the conversion today, only to see their Medicare premiums jump two years later, hitting their fixed-income budgets hard.
When Conversions Actually Work
Roth conversions can be a smart move when your future tax rate is significantly higher than your current one. This is often the case for retirees who are in a lower tax bracket now but will be pushed into a higher bracket when they start taking RMDs. A partial conversion can make sense in this scenario, as it takes advantage of the arbitrage between current and future tax rates.
However, for retirees already in the 24% or 32% tax bracket, conversions may not be beneficial. If their RMDs will push them into a similar tax bracket, they are essentially prepaying tax for no benefit. Adding IRMAA to the mix can result in negative arbitrage, where the total tax paid exceeds the potential savings.
What to Do Before You Sign
Before making a decision about Roth conversions, retirees should consider the following:
- Build All Three Buckets: Diversify your tax strategy by including after-tax brokerage, traditional pre-tax, and Roth accounts. This provides flexibility and ensures you have options for different years.
- Run the Marginal vs. Effective Math: Calculate your effective tax rate and compare it to the marginal tax rate a conversion would trigger. The gap represents the real cost of the conversion.
- Model IRMAA Two Years Forward: Use current Medicare IRMAA brackets and project your Modified Adjusted Gross Income (MAGI) to estimate the impact on your Medicare premiums.
- Convert in Small Slices: If conversions make sense, start with filling the bottom of a tax bracket rather than the top. Stop before crossing into a higher bracket or triggering an IRMAA tier.
Conclusion
Roth conversions can be a double-edged sword for retirees. While they offer the potential for tax-free growth, the immediate tax bill and the potential impact on Medicare premiums can be significant. It's crucial to carefully consider your financial situation, tax bracket, and future income projections before making a conversion. By taking a thoughtful approach and seeking professional advice, retirees can make informed decisions that align with their long-term financial goals.
