Mike Piper for The Oblivious Investor writes: I recently finished reading Dana Anspach’s new book Control Your Retirement Destiny (highly recommended, by the way — you can see my review here) and found the author’s ideas on Roth conversions in retirement to be quite worthy of sharing.
As a bit of background, the big question when considering a Roth conversion is, “how does my marginal tax rate right now (i.e., the tax rate I would pay on the conversion) compare to the marginal tax rate I expect to have when I’m spending this money?”
If you’re over age 59.5, it usually makes sense to do the conversion if your current marginal tax rate is less than or equal to the marginal tax rate you expect to have when you spend the money. (Exception: If you expect the IRA to be left to your heirs, the relevant question becomes how you expect your current marginal tax rate to compare to the IRA beneficiary’s marginal tax rate at the time he/she will be taking the money out of the IRA.)
In her book, Anspach makes the case that, for a few reasons, your marginal tax rate later in retirement may be higher than you might expect.
Social Security Taxation
As we’ve discussed before, the unique way in which Social Security is taxed often leads to situations in which taxpayers have marginal tax rates that are far higher than just the tax bracket they’re in. For example, it’s possible for a Social Security recipient to be in the 15% tax bracket, yet have a federal marginal tax rate of 27.75%, because each additional $100 of income not only results in $15 of regular income tax, it also causes $85 of Social Security benefits to become taxable, thereby resulting in another $12.75 of income tax.
Because of this unique tax treatment for Social Security income, it’s very often true that if you have years of retirement prior to receiving Social Security, your marginal tax rate in those years is significantly lower than the marginal tax rate you will have after you start receiving Social Security. Conclusion: Roth conversions in these years are often advantageous.
Death of a Spouse
Anspach also bring up a point that I don’t think gets nearly enough attention (and, for the record, I’m as guilty as anyone, as I don’t believe I’ve covered it in an article before): A widow/widower’s marginal tax rate in retirement is often higher than the marginal tax rate that the couple had while they were both still alive.
The reason this often happens is that a single person’s 10% and 15% tax brackets, standard deduction, and personal exemption are each half as large as those for a married couple filing jointly, yet a surviving spouse’s income will often be well above 50% of the income that the couple had — because he/she will get to keep the larger of the two Social Security benefits and because portfolio-sourced income will stay the same.
As a result, Roth conversions during retirement can sometimes make sense for married couples as a way to best prepare for the period of widowhood/widowerhood.
Medicare Premiums
Premiums for Medicare Parts B and D are a function of your modified adjusted gross income. (For these purposes, MAGI includes tax-exempt interest income.) But rather than operating on a sliding scale, they ratchet upward in steps. For example, if your MAGI exceeds $85,000 ($170,000 if married filing jointly), your monthly premium will be $40 higher than it would be if your income was below that level.
While this isn’t technically a tax, it has the same effect from a financial planning standpoint. That is, the dollars of income that put your MAGI just barely above the applicable thresholds in effect have a very high marginal tax rate. As a result, Roth conversions can sometimes make sense for retirees who are not yet eligible for Medicare, if the conversions allow them to stay just under the threshold once they are eligible for Medicare.
Do The Math
While the three points above do result in advantageous Roth conversion circumstances for many retirees, the point Anspach really hammers home in her book (a point with which I fully agree) is that you have to actually do the math with your own figures. This is not the sort of thing where a rule of thumb works very well.
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