Timing Is Everything
Conventional wisdom says that it’s best to wait until retirement to convert a traditional IRA into a Roth IRA, which allows money to grow tax free. The theory is based on the belief that most people will have lower incomes and be in lower (certainly not higher) tax brackets. And that much is usually true.
However the decision is not so simple. There are many potential benefits to conversion. Anyone can do it – there are no longer any income limitations, but choosing the right timing can be complex. Yes the marginal tax bracket the conversion income is likely to be subject to is a major factor in the decision, but the timing of the additional income generated by the conversion can create issues with other retirement programs, mainly Social Security and Medicare.
Taking the conversion after retirement will almost certainly expose more of your Social Security earnings to taxation which may have been avoided. Of course the alternative to this is to delay or suspend Social Security until after the conversion year(s) – which also has other potential benefits.
Another major issue is the spike in income from conversion could also cause your Medicare Part B & D premiums to increase in the years following due to IRMAA’s (Income Related Monthly Adjustment Amounts). This was recently made more critical with the passage of the Medicare Access and CHIP Reauthorization Act of 2015 (otherwise known as "Doc Fix"). Among other things, this law decreases the thresholds of MAGI (Modified Adjusted Gross Income) based increases in Medicare Part B & D premiums. In plain English, this means you would pay higher Medicare premiums at even lower incomes. This can amount to hundreds of dollars per month in additional part B & D premiums due to higher income in the conversion year.
Because of the change in the law, a married couple would only have to drive their MAGI above $320,000 in 2016 to reach the top Medicare premium tier vs. $428,000 in 2015. Any savings in tax from waiting to convert could easily be erased by higher Medicare premiums. In fact a couple getting bumped from the base premium to the top tier due to a conversion could face a premium surcharge of over $4,000 two years after the conversion.
There are other factors to consider as well. It’s best to have the cash on hand to pay the additional taxes at time of conversion. That may or may not be more accessible after retirement. There is also the issue of deduction and other tax benefit phase outs due to higher incomes. It might be best to time the conversion to coincide with years where those issues are less impactful.
In the end the timing of a Roth conversion is complex and unique to every situation. It’s one that warrants planning before retirement.
The Bottom Line: Changes taking effect in 2016 warrant consideration of converting IRA and other Qualified accounts to Roth IRA’s in 2015.