Your Roth Conversion Balancing Act

Summary

• Large “pre-tax” retirement fund accumulations will likely lead you to the need to consider Roth conversion strategies

• The “sweet-spot” for Roth conversions is typically between age 60 and 72

• Roth conversions during those “sweet-spot” years, if not carefully planned, could trigger the Medicare premium surtax, otherwise known as IRMAA

• IRMAA-related Medicare Part B surtax need not become a Roth conversion planning “poison pill” for you

• Planning considerations should include any potential for tax liabilities left to non-spousal beneficiaries of your retirement funds
   

If you are a pre-retiree (between age 55 and 60), or an early retiree from the workforce (age 60 to, say, 65) and have accumulated significant retirement fund balances within those accounts, you may soon be faced with Roth conversion considerations for your retirement portfolio. This is particularly so if your accumulated retirement funds are mostly of the “pre-tax” variety, either tax-deferred 401(k) accumulations and/or traditional IRA accounts. Roth conversions have, in fact, become somewhat of a necessary inconvenience for many retirees lately. This “inconvenience” happens essentially on two fronts; 1) the need to reduce the certain tax liabilities you are on track to face during your middle-to-late (post-72) retirement years, and, 2) your need to consider future tax liabilities left for non-spousal beneficiaries once they should inherit your retirement savings down the road. Whether your investments are inside a company 401(k) or accumulated/rolled over into an IRA account, the recently mandated required distribution realities brought about by the SECURE Act in 2019 have engendered a strong need for you to plan how to leave unspent retirement accumulations to those beneficiaries, either as a tax liability to them (“pre-tax” retirement fund distributions) or as “after-tax” Roth distributions.   

Roth conversion “sweet spot” for retirees – from age 60 to 72

Depending on the size of your retirement portfolio in combination with your other income sources at the time of retirement, the “sweet spot” for many retirees to consider Roth conversions occurs shortly after retirement begins and those years just before required minimum distributions (RMD’s) will begin --- between age 60 and 72. It is during these early retirement years that retirees often find themselves in lower tax brackets. This is due to having replaced salary/wages, typically at peak earnings, with retirement income from various sources (including Social Security, pension income, part-time income, spousal wages and such). Converting to “after-tax” Roth retirement funds typically makes the most sense during these “sweet spot” years. Though conceivable from a planning perspective, most won’t likely wish to pursue Roth conversions beyond age 72 (once RMD’s kick in) by reason of wanting to avoid the double-whammy of tax liabilities from electing to convert while simultaneously receiving RMD’s during those years. And pre-retirees are not excluded from their own opportunity to convert from “pre-tax” to “after-tax” retirement funding. Just know the rules and/or work with a financial advisor to plan your own Roth conversion strategy.

Given the two taxation inconveniences mentioned in the opening paragraph above, this process of converting from “pre-tax” retirement funds to “after-tax” retirement funds will also likely become a balancing act between your desire to minimize future taxation of retirement distributions and the necessity to avoid a third inconvenience, triggering the Medicare premium surtax, also known as the Income-Related Monthly Adjustment Amount (IRMAA).

Medicare’s Income-Related Monthly Adjustment Amount (IRMAA)

The Medicare premium surtax (IRMAA), is an adjustment to Medicare Part B premiums paid by higher-income Medicare beneficiaries. IRMAA kicks in for those “higher-income” Medicare beneficiaries when adjusted gross income for single taxpayers exceeds $88,000, and exceeds $176,000 for married couples filing joint returns. For 2021, the first tier of IRMAA surtax adds a cost increase of $59.40 per month, increasing Medicare Part B premiums from $148.50 per month to $207.90 per month. Married filing jointly and both Medicare eligible? The IRMAA surtax would implicate both Medicare enrollees. There presently are six tiers of IRMAA-related Medicare Part B premium levels with Medicare Part B premium levels increasing to as high as $504.90 per month for those Medicare enrollees in the highest IRMAA earnings brackets. Medicare premium surtax levels are likely be annually adjusted ever higher and higher out into the future. Understanding how IRMAA-related Medicare Part B premium adjustments could impact your retirement is of considerable planning importance.

Most retirees won’t realize adjusted gross income levels high enough to find themselves captured by those highest tier levels of IRMAA-related Medicare Part B adjustments. But many others could easily find themselves captured into the lower tiers of the IRMAA surtax. During those “sweet spot” years for pursuing, what now have become for many, very necessary Roth conversions, the amount you actually convert being construed as taxable income would be inclusive in your adjusted gross income, and thus could bump you into IRMAA-related Medicare Part B premium adjustments for a time. It is important here to understand that a two-year lag exists for determining a Medicare beneficiary’s level of adjusted gross income. So, for new Medicare beneficiaries enrolling in 2021, income earnings levels from 2019 are used to determine if there would be an IRMAA surtax.

And so a balancing act exists from a financial planning standpoint to determine an appropriate amount of “pre-tax” retirement funds to convert to “after-tax” retirement funds as you undergo your own Roth conversion strategy. The sources of income during those early retirement years (including Social Security, pension income, part-time income, spousal wages and such) coupled with the amount of your Roth conversion in any given tax year could quickly bump you into an IRMAA-related Medicare Part B surtax level.

IRMAA not necessarily a planning “poison pill”

The potential for realizing IRMAA-related Medicare Part B surtax need not become a Roth conversion planning “poison pill” for you. Your retirement income strategy foremost needs to consider income tax implications for yourself (and/or your spouse/partner) during your own retirement lifetime(s). Triggering IRMAA-related surtax early in your retirement while converting to “after-tax” Roth retirement funds can still be the path of least tax resistance in the long run. Your decision not to convert at least a portion of your accumulated retirement funds to Roth “after-tax” status can be quite costly to you; costly especially during those later, post-72 RMD heavy retirement years, as annual required and systematic distributions from your retirement accounts kick in. Retirees with sizeable retirement accounts are strongly encouraged to understand the implications of post-72 RMD income taxation from your “tax-deferred” retirement funds. Your RMD’s do grow annually over time and very likely could bump annual adjusted gross income into higher tax brackets during your later retirement years. As necessary and unavoidable RMD’s bump your adjusted gross income level into higher taxation brackets, there could be no avoiding IRMAA-related surtax in those years. For those retirees the necessity to visit the benefits of Roth conversion strategies is paramount.  

Leaving your heirs with a tax trap?  

Have you further considered the tax liabilities you are setting up for your non-spousal beneficiaries once they should inherit your retirement savings? The SECURE Act has brought about significant changes to how those non-spousal beneficiaries will need to take their own distributions from the retirement savings inheritances they are to receive from you. At the time they inherit these funds, what will be the taxation realities they will face? Will tax brackets likely be lower than today’s brackets or higher out into the future? Will those beneficiaries find themselves paying necessary taxes on distributions during their own peak earnings years, thus bumping them into ever higher taxation brackets?
      
Roth conversion strategies are today, more critically than ever, a serious financial planning consideration for many pre-retirees and early retirees. You should begin to assess your need to consider Roth conversion strategies as you approach your retirement years, or even earlier, while still within your prime earnings years. You should consider the pros and cons of deferring retirement funds within employer-based retirement plans (401(k) and 403(b) type plans) to Roth-type employer-based retirement accounts, if available within your employer-based plan, as well as making annual retirement contributions to Roth IRA’s as opposed to Traditional IRA’s, where appropriate. If you are unsure how to assess the impact of these planning decisions, consider working with a knowledgeable financial advisor who can help you understand the longer-term planning implications of the choices you need to be considering.
 

Mark W. Petro is a financial advisor and President of Lakeland Investor Services, Inc., a Registered Investment Advisor in Conneaut Lake, Pennsylvania.

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