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Many financial planners are recommending Roth IRA conversions these days. That’s when you take a taxable distribution from your traditional IRA and change it to a Roth IRA.
But should you?
“For some people, a Roth conversion can be a wonderful tax-saving strategy, but for others, it may not be advantageous,” says Philip Herzberg, a certified financial planner with Lubitz Financial Group in Miami.
Here are the basics.
A Roth IRA has three main features. Like a traditional IRA, assets in the account grow tax-free. But unlike a traditional IRA, contributions are made with after-tax dollars and withdrawals or distributions from Roths are tax-free.
Here’s what you need to think about when considering a conversion:
Tax rates rising
The possibility of ordinary income tax rates rising is one big reason experts are recommending Roth IRA conversions now. By making the change, traditional IRA distributions will be taxed at a lower rate than in the future, experts say. And future Roth IRA distributions will be tax-free.
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Unintended consequences of Roth IRAs
Experts advise against Roth IRA conversions in the absence of a complete set of facts. Why so? There are many unintended financial consequences that come with Roth IRA conversions. That’s one reason why experts recommend talking to a qualified professional before executing a Roth IRA conversion.
Here are some issues to consider:
Will Roth IRA conversion hike Medicare premiums?
If you’re a Medicare beneficiary (or will be one in two years), the amount you convert from your traditional IRA is considered ordinary income, and that amount could subject you to something called the “income-related monthly adjustment amount.” Taxpayers whose modified adjusted gross income is above certain amounts have to pay extra for their Part B and Part D premiums.
“The upshot is you could be paying around $840 per year more in Medicare Part B & D premium costs,” Herzberg says.
Will the conversion subject you to Medicare surtax? High-income taxpayers – and you could be become one because of the Roth IRA conversion – have to pay a 3.8% “net investment income tax,” also known as the Medicare surtax.
Will my advance premium tax credit be reduced?
If you receive, under the Affordable Care Act, a tax credit to lower your monthly health insurance payment or premium, it’s possible that you’ll have to pay the excess back because of the Roth IRA conversion. The credit is based on expected income and a Roth IRA conversion could result in a higher actual income for the year.
“The higher premiums can easily exceed the ‘tax savings’ which are not a certainty,” says Jae Oh, author of “Maximize Your Medicare.”
Will my Social Security be taxed?
Herzberg typically advises against a Roth IRA conversion if you have already started taking your own Social Security benefits or required IRA distributions.
“You may push yourself into the next highest tax bracket when you move money from your IRA to a Roth IRA,” he says. “With a Roth IRA conversion, a higher percentage – 50% to 85% – of your Social Security benefits may become taxable, as well.”
Will my capital gains be taxed at a higher rate?
The Roth IRA conversion may bump your federal marginal tax rate from 10% or 12% to 22%.
“Those who are in the 10% and 12% bottom two ordinary income tax brackets are eligible for a zero percent long-term capital gains rate on any capital gains and qualified dividends that also fall within those tax brackets,” Herzberg says. “Long-term capital gains rate spikes to 15% on the same investment activity within the higher 22% federal marginal tax bracket.”
Will I lose my ability to deduct medical and dental expenses?
According to Herzberg, the increase in adjusted gross income resulting from a Roth IRA conversion may lower the amount of itemized medical and dental expenses that are tax-deductible. You may deduct only the amount of your total medical expenses that exceed 7.5% of your adjusted gross income.
Should I delay moving to a high-income tax state?
Roth IRA conversions are, Herzberg says, “not favorable if you are about to move from a low-income tax state, such as Florida, to a high tax state, which will significantly increase your future taxes.”
Robert Powell, CFP, is the editor of TheStreet’s Retirement Daily (www.retirementdaily.net) and contributes regularly to USA TODAY. Got questions about money? Email Bob at [email protected]
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