Converting your traditional IRA to a Roth IRA can have a significant impact on your premiums if you are a Medicare beneficiary. But if you are not yet receiving Medicare, there is no impact on your payroll deductions. Conversion to a Roth IRA may sound enticing, but it is not a wise move in every case. It's best to consult a tax professional who can help you understand the full scope of what conversion would mean from a Medicare and a tax liability standpoint in your particular circumstances.
Roth vs. Traditional IRA
The key question is, “When do you want to pay your taxes?” Neither a traditional nor a Roth IRA avoids tax. With a traditional IRA, the money you put into the account is from pre-tax dollars, but you pay income tax when you withdraw money from the account, and you must start withdrawing at age 70 ½. A Roth IRA front-loads the income tax and withdrawals are tax-free if you've had the account for at least five years and you are at least age 59 1/2. For both forms of IRA, you pay Medicare tax -- embedded in FICA deductions from your paycheck -- on the money that you contribute to your IRA. You do not pay FICA when you withdraw money from your IRA.
When you convert a traditional IRA to a Roth IRA, you’re taking money that was not taxed and rolling it into a tax-free account. Obviously, the government won’t let you skip paying taxes, so the amount you convert is treated as income for that tax year. If you are a Medicare beneficiary, this can have a significant impact because it may cause you to pay the high-income surcharge for Medicare Part B and Medicare part D, which comes into play when your income surpasses the $85,000 mark if you’re single and $170,000 if you are married. For example, in 2011, people below the this threshold paid $115.40 per month for Medicare Part B and those above the limit paid at least $161.50. Monthly premiums increase incrementally according to income, for example, up to $369.10 in 2011.
If you and your spouse hold separate traditional IRA accounts and you believe a Roth IRA conversion makes sense in your circumstances, consider converting your accounts in different tax years. This will reduce your total income for the year and could result in lower Medicare premiums, but you’ll pay the higher amount for two years instead of one.
Another strategy is to convert your traditional IRA to a Roth in increments over several tax years. If you are a Medicare beneficiary, you will pay higher premiums over more years, but you may be able to keep your income below the high-income surcharge level, or at least in a lower Medicare bracket, which could cost you less money in the long run. You are, however, taking a risk that both Medicare premiums and income taxes will go up over the intervening years, which could wipe out the advantage of the lower bracket.
If You Don't Convert
With a traditional IRA, both the money you put into the account and the earnings over the years are subject to income tax. Your required minimum distribution begins at age 70 ½ and all of it is treated as income. The net effect could be a significant increase in yearly income at that age, which means that you’ll pay higher Medicare premiums, not just for that year, but for the rest of your life. That may be OK if you have a relatively low income, but it could hurt if you’re in a higher income bracket. By contrast, both earnings and principal in Roth IRA accounts are tax-free – meaning they don’t count as part of your income -- and there is no requirement for withdrawal at any age.
- Kiplinger.com; Tax Rules for Roth Conversions; Kimberly Lankford; May 2010
- Kiplinger.com; Health Care Reform and Roth Conversions; Kimberly Lankford; April 2010
- IRS.gov; Publication 15: Employer’s Tax Guide; 2011
- Elder Law Answers; New Medicare Premium, Deductible and Co-Pay Charges for 2011; February 2011
- LoopholeLewy.com; Form W-2 Reporting for Simple IRA Contributions; Larry Villano
- Jupiterimages/Comstock/Getty Images