Table of Contents
Roth Conversions and the Effects of Medicare
Income-Related Monthly Adjustment Amounts (IRMAA)
by Steven T. Kohman
Certified Public Accountant
Certified Specialist in Estate Planning
Certified Specialist in Retirement Planning
We all would like to have more in Roth IRAs than Traditional IRAs since they grow tax-free and there are no Required Minimum Distributions (RMDs) for the owner. Additionally, if your children or grandchildren inherit your Roth IRA, the inherited Roth IRA can continue to grow income-tax-free for ten years after the death of the IRA owner. In contrast, inherited Traditional IRA distributions over ten years may cause higher income and higher tax rates for those years. To get more in Roth IRAs and less in Traditional IRAs, a taxable Roth conversion is the only option for most retirees.
The costs of making a Roth conversion must be considered when deciding how much to convert in any given year. For people who are under age 63, income taxes are the primary cost of doing a conversion in 2021. For people who are older and going to be on Medicare in 2023, please see below regarding the lag between additional income and additional premiums. The potential for additional Medicare Income-Related Monthly Adjustment Amounts (IRMAA costs) should also be considered as an extra cost of doing the conversion. In this article, we will look at how significant these additional IRMAA costs are in relation to the Roth conversions. All the costs discussed in this article are based on the Married-Filing-Joint (MFJ) costs for married couples.
Without IRMAA costs, the income tax bracket rates of 10%, 12%, 22%, 24%, 32%, 35%, and 37% are useful as a guide to quantify your conversion costs. There are additional costs beyond the income tax brackets. For example, the additional income from the Roth IRA conversion increases other taxes like Net Investment Income tax when your AGI exceeds $250,000. The additional income from the Roth IRA conversion could also impact what would have otherwise been tax-free qualified dividends and/or long-term capital gains when taxable income stays below $80,800. The additional income could trigger the higher 20% tax rate rather than the normal 15% tax rate on qualified dividends and long-term capital gains when your taxable income exceeds $501,600. For lower-income taxpayers receiving Social Security income, some of the Social Security income maybe not fully 85% taxable without a conversion but would become 85% taxable with a Roth conversion.
At the end of each year, the Social Security Administration determines how much Medicare premiums including IRMAA costs you will have to pay for the coming year based on the most recently filed tax return. For 2021, Medicare premiums are based on your 2019 income. Similarly, the 2023 Medicare premiums will be based on your 2021 income which may include Roth conversion income.
IRMAA costs increase the Medicare premiums when your Modified Adjusted Gross Income (MAGI) exceeds certain amounts. MAGI is the AGI plus tax-exempt dividends and interest on your tax return. For 2021 Medicare premiums, the IRMAA cost increases start with MAGI’s over $176,000 and more increases with MAGI’s over $222,000 and $276,000 and $330,000 and $750,000.
These extra 2021 IRMAA Medicare premiums cost increases for a MFJ couple on Parts B and D of Medicare for a full year are as follows:
- $1,721 for MAGI over $176,000 but under $222,000
- $4,327 for MAGI over $222,000 but under $276,000
- $6,931 for MAGI over $276,000 but under $330,000
- $9,538 for MAGI over $330,000 but under $750,000
- $10,404 for MAGI over $750,000
It is important to know that if you are over the MAGI limits by any amount you will be charged the extra Medicare premiums. For example, if you convert $1 too much and make your MAGI $176,001, you will have the extra $1,721 of Medicare premium costs. It makes sense to keep the conversion low enough to safely stay under the applicable income level in most cases.
It is also important to know that over the last couple of years, these MAGI levels have increased for inflation. By the time they calculate the IRMAA increase levels for 2023 Medicare premiums based on 2021 income, these levels could be higher. They also change the extra premium increase amounts from year to year so the extra premiums could be higher by then.
Avoiding IRMAA Costs Initially
These IRMAA increases can potentially be avoided in the first year after you have a “life-changing event” by filing Form SSA-44. A life-changing event includes retirement, death of spouse, marriage or divorce, loss of pension or a few other rare circumstances, not including Roth conversions. The most common one is when you retire after making a lot of money, but now retired, your income will be less. Using the 2019 tax return with high income before retirement may not be representative of the lower-income you will have in 2021 after retirement. The SSA-44 is a way to get excused from the IRMAA Medicare premium increases in that situation, possibly saving you thousands of dollars.
These extra IRMAA costs affect the overall cost of Roth conversions. As a basic example, let’s assume that without the Roth conversion, the 2021 MAGI is $139,500 and the taxable income without a Roth conversion is $111,700 and ignore the complications of investment income and other factors so ordinary taxable income is also $111,700. This is in the 22% tax bracket.
- A Roth conversion of $36,000 can be done to keep the MAGI under the first Medicare premium increase level at a tax cost of 22% since the taxable income is still in the 22% tax bracket.
- A Roth conversion of $82,000 can be done to keep the MAGI under the next Medicare premium increase level at an incremental tax cost of 22.91% above the $36,000 conversion since this is partly in the 22% and partly in the 24% tax bracket. But the estimated extra Medicare premiums of $1,721 make the incremental cost 26.65%. The IRMAA cost is 3.74% of the extra conversion.
- A Roth conversion of $136,000 can be done to keep the MAGI under the next Medicare premium increase level at an incremental tax cost of 24% above the $82,000 conversion since this is in the 24% tax bracket. But the estimated extra Medicare premiums of $2,606 make the incremental cost 28.83%. The extra IRMAA cost is 4.826% of the extra conversion.
At this point, you may want to only convert $82,000 instead of the $136,000 because this extra IRMAA cost is higher than the first level of IRMAA cost. In addition, if there is investment income, there would be more conversion costs from the additional net investment income tax of 3.8% of the amount of investment income to the extent of the AGI that exceeds $250,000. In this example, the AGI is $275,500 with the $136,000 conversion. If the income included $25,500 of investment income, there is an extra $969 of tax cost to consider.
- A Roth conversion of $190,000 can be done to keep the MAGI under the next Medicare premium increase level at an incremental tax cost of 24% above the $136,000 conversion since this is still in the 24% tax bracket. But the estimated extra Medicare premiums of $2,604 make the incremental cost 28.82%. The extra IRMAA cost is 4.822% of the extra conversion.
- If a larger conversion is done to the top of the 24% tax bracket, it would only be a $218,150 conversion or $28,150 more than the $190,000 conversion. The extra Medicare premiums result in an incremental cost of 33.26% which is the 24% tax cost plus an extra 9.26% for the IRMAA cost. This is very high, so if you wanted to convert at least this much, it may make sense to convert $307,150 to the top of the 32% tax bracket at an incremental cost of only 32% because there would be no additional IRMAA cost over the $218,150 conversion. Similarly, if it makes sense to convert to the top of the 35% tax bracket with a $516,600 conversion, there is again no additional IRMAA cost over the $307,150 conversion.
As you can see, the IRMAA increases typically add at least about 3.8% or 4.8% to the cost of Roth conversions when you exceed the various levels unless you do a very large conversion or if you have high IRMAA costs (MAGI over $330,000) even without a Roth conversion.
Recovering IRMAA Costs Paid on Larger or Multi-Year Conversions
On the other hand, doing larger Roth conversions at once or over a period of years will lower your future taxable RMDs. For a 75-year-old person, having $500,000 less in Traditional IRAs due to conversions, will reduce the RMDs by about $22,000 initially and likely by more in future years. This lower income could result in settling under an IRMAA income level whereas, without the conversions, you would be over it. If this situation continues for several years, the additional IRMAA costs paid due to conversions could be recovered in future years. In addition, if the $22,000 of extra income without the conversions is in a higher tax bracket (say 32%) than the tax bracket level with the conversions (say 24%), there could be additional income tax savings from the conversions to help offset extra IRMAA costs of the conversions done.
The decision on the actual amount of Roth conversions to do in your situation is beyond the scope of this article and would depend on many factors. If Roth conversions generally make sense in your situation, and you are covered by Medicare, if you keep your conversion small enough to stay under the applicable IRMAA income level, it is likely a good minimum amount of Roth conversions to do in many situations. In other situations, converting larger amounts to Roth may make sense despite these additional IRMAA costs. For example, if you are taking into consideration the benefit for your heirs of you making a Roth IRA conversion, the extra IRMMA costs might not weigh so heavily.
Determining how much and when you should make a Roth conversion is a tricky calculation. Many taxpayers will get the optimal result not by doing just one conversion in one year, but a series of smaller Roth IRA conversions over multiple years.
One method you may consider is to calculate a long-term Roth IRA conversion plan that may involve a partial Roth IRA conversion over a series of years. Then, update the calculation every year based on changes in investments, tax rates, liquidity to pay the taxes, etc.
Whichever method you use to calculate Roth IRA conversions, however, you should be taking the additional conversion IRMAA costs into the calculation.
The Dreaded SECURE Act and The New Administration
Threaten Your IRA and Retirement Plan with Massive Taxation
Million-Dollar IRA Owners Must Take Action to
Maximize Retirement Prosperity and Generational Wealth
Webinar Dates: Tuesday & Wednesday, March 30 & 31, 2021
Register to attend at https://PayTaxesLater.com/Webinars
TUESDAY, MARCH 30, 2021
Session 1: 10 AM – NOON
Proven Strategies to Protect Yourself and Your Family from Devastating Tax Losses
- Avoid the decimating tax-accelerating consequences of the SECURE Act.
- Inherited IRAs and other inherited retirement plans (with some exceptions) now face accelerated taxation—basically, the inherited account must be totally withdrawn within 10 years of the death of the original owner.
- Reduce your income tax liability.
- Likely long-term tax rate increases make it prudent for many to transfer assets from the taxable world to tax-free world. For example, take a portion of your IRA and consider:
- Roth IRA Conversions (which we will cover in-depth including concepts and numbers).
- Withdrawing an amount, paying the taxes, and gifting the proceeds to the second or third generation.
- Withdrawing an amount, paying the taxes, and using the proceeds for a 529 Plan (education for grandchildren) or life insurance, which if done correctly are income and estate tax-free.
- Minimize the impact of potential tax increases—other than income tax.
- Less obvious increases might come from eliminating the current step-up in basis provision and the favorable capital gains rates.
- Optimize your Social Security distributions.
- Update your estate plan (see Session 3).
- Combine several of the strategies listed here.
Session 2: 1:00 – 3:00 PM
Live Q&A with James Lange: Ask Me Anything!
Jim will answer attendees’ questions submitted in advance of the webinar as well as during the webinar. This is a golden opportunity to get straight—and personalized—answers to your most perplexing retirement questions. What haven’t you thought of? Learn even more from listening to the questions and answers from others who are in similar circumstances.
WEDNESDAY, MARCH 31, 2021
Session 3: 10 AM – NOON
The Best Estate Plan for Married IRA Owners After the SECURE Act and the Election
- How to minimize the impact of the SECURE Act and potential new tax decisions that will affect your estate plan.
- Should you consider a charitable remainder trust as the beneficiary of your IRA?
- In 2026, the estate tax exemption—to oversimplify, the amount that you can die with before there is a transfer tax—is likely to be reduced from the current amount of $11.7 million (or $23.4 million if you are married) to $5 million (or $10 million if you are married). We will cover the likely federal estate tax changes, but the majority of the program will concentrate on income tax reduction, not estate transfer tax reduction at death.
- Who Gets What? Innovative strategies for IRA owners who want to leave at least some money to charity—but not necessarily at the expense of the family.
- How to accommodate children of unequal financial strength (very few estate attorneys are using these strategies and it could save your family tens or even hundreds of thousands of dollars in taxes).
Session 4: 1:00 – 3:00 PM
Live Q&A with Larry Swedroe and Corey Altman of Buckingham Strategic Wealth and James Lange: Get Answers to Your Questions on Investing, Wealth Management and Preservation and More
Larry, Corey, and Jim will answer attendees’ questions submitted in advance of the webinar as well as during the webinar. Another golden opportunity to have your most nagging investment questions answered.
Larry Swedroe, Chief Research Officer of Buckingham Strategic Wealth, educates individuals on the benefits of evidence-based investing. Larry has authored nine books and co-authored seven books on investing, including his newest book, Your Complete Guide to a Successful & Secure Retirement. Larry has made appearances on NBC, CNBC, CNN, and Bloomberg Personal Finance.
Corey Altman, CPA/PFS serves clients by implementing evidence-based investment strategies and holistic financial plans to help them attain their future goals. Corey thrives on results and loves to see a comprehensive plan deliver financial peace of mind.
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