Shane Tenny, CFP®, discusses the considerations for retirees who want to convert a pre-tax IRA to a Roth IRA. While it can be a beneficial strategy, there are several unpleasant side effects to be aware of.
Transcript:
[00:00:02.270 --> 00:00:17.160] Hi, everyone, Shane Tenney here with Spawner and Tenny to talk about one of the most common strategies that is discussed with regard to retirement tax planning. And that is the IRA to Roth conversion.
[00:00:17.250 --> 00:00:33.239] Now, if you're not familiar with this, let me just take a minute and explain what this is. And the point of the video, though, is to make sure you are aware of some of the unintended consequences that sometimes come about through this strategy.
[00:00:33.240 -->:00:42.380] As you know, through the course of your working years, you've deferred money into retirement plans, which are often rolled into an IRA at retirement.
[00:00:42.490 --> 00:00:51.450] This IRA is constituted with pre-tax retirement money, and when you withdraw it you will have to pay income taxes on the balance.
[00:00:51.530 --> 00:01:07.959] Many people become aware of a Roth IRA, which allows money to be withdrawn tax-free. And so one of the strategies often written about in financial publications or talked about by financial advisors is converting your IRA to a Roth IRA.
[00:01:08.010 --> 00:01:14.840] In so doing you'll avoid paying the income tax on the distributions because Roth IRAs are tax-free.
[00:01:15.060 --> 00:01:25.339] However, to convert money from a pre-tax IRA to a Roth IRA, you do have to pay income taxes in the year of that transaction.
[00:01:25.650 --> 00:01:55.150] The reason this strategy is of interest is because for many retirees they find themselves in a lower income tax bracket than when they were working. And so, the notion of having deferred income taxes during their high-income years and potentially paying a lower tax bracket in retirement to convert the money to Roth seems like a good deal. And then they'll be able to withdraw money from the Roth IRA tax-free later on, or leave it to their heirs. Who can then withdraw the money tax- free?
[00:01:56.350 --> 00:01:59.939] With this said, there are a couple of things to be aware of.
[00:02:00.220 --> 00:02:04.520] The first is the impact of this on Medicare premiums.
[00:02:04.650 --> 00:02:19.970] Although Medicare Part A, available to anyone over 65, is free, Medicare part B and D, the physician and drug coverage plans, are not free, and the premium for these plans is means tested.
[00:02:20.020 --> 00:02:37.539] This means that the premium for Medicare Part B is based on your prior year’s income and can range anywhere from about $174 per individual to $400 per individual, depending on what your previous year's modified, adjusted, gross income is.
[00:02:37.770 --> 00:03:02.029] Now, why do I bring this up doing an IRA to Roth conversion creates a year in which you temporarily have a higher posted taxable income and therefore, the result will be the following year's Medicare Part B premium will be higher and could be significantly higher, maybe 2 or 3 times higher.
[00:03:02.660 --> 00:03:12.750] You want to be aware of this when factoring in the expected cost, both tax-wise and premium wise, for doing an IRA to Roth conversion.
[00:03:13.450 --> 00:03:28.059] It's also important to take into consideration not only your own income tax bracket relative to your working years and retirement years but also the income tax bracket of any individuals, usually children, who may inherit the monies.
[00:03:28.250 --> 00:03:39.710] While your retirement income tax bracket may be lower than when you were working. It still may be higher than the income tax bracket of your children, who would stand to inherit the money.
[00:03:39.770 --> 00:03:53.040] And therefore, paying income tax of any kind now is unnecessary from a cumulative standpoint because it's still higher than what your children would pay if they would inherit the IRA.
[00:03:53.400 --> 00:04:04.409] Therefore, converting the money from IRA to Roth and paying an income tax burden now only to leave the Roth tax-free to them, still results in higher cumulative tax.
[00:04:05.770 --> 00:04:24.560] The final point I want to bring up is that if you are in your 70s, and of an age where required IRA distributions have started, you cannot convert required minimum distributions to a Roth IRA. Those have to be taken out, and you have to pay income taxes on them.
[00:04:24.670 --> 00:04:35.479] So, once you are of RMD age, the only way to affect a Roth conversion would be to take out additional money above and beyond your RMD.
[00:04:35.540 --> 00:04:39.550] And this often becomes fairly punitive from an income tax standpoint.
[00:04:40.280 --> 00:04:56.519] So, a few points of consideration. This is not to say that converting IRAs to a Roth is a bad idea or not worth considering in retirement. Just to make sure you're aware of all the potential pros and cons of that transaction.
[00:04:56.750 --> 00:05:02.880] Hope this helps; feel free to reach out. If any questions come to your mind and we can be of help in any further way.
[00:05:02.960 --> 00:05:04.889] We'll see you back here for the next video soon.
Any discussion of taxes is for general information purposes only, does not purport to be complete or cover every situation, and should not be construed as legal, tax, or accounting advice. Clients should confer with their qualified legal, tax, and accounting advisors as appropriate.
