Roth IRAs have been available since 1998. In spite of their being advertised as a financial panacea, Roth IRAs may not be financially suitable for all individuals. At this time late in the year, many traditional IRA owners are being advised to convert their traditional IRAs to Roth IRAs. The failure to understand the possible downsides of a Roth IRA conversion could be problematic for the Roth IRA owner.
This column discusses some of the problematic consequences when Roth IRA conversions.
Problem #1: Increase in Adjusted Gross Income (AGI)
The income resulting from a Roth IRA conversion will increase the Roth IRA owner’s adjusted gross income (AGI) for the year of conversion. An increase in the Roth IRA owner’s AGI could result in the possible loss of valuable tax credits and deductions (which are “phased out” if one’s AGI is above certain AGI amounts), taxation of Social Security benefits, and “stealth taxes” (such as the net investment income tax or NIIT and Medicare Part B and Medicare Part D IRMAA). While the possible loss of tax deductions and credits happens only for the year of conversion, these negative consequences must be considered. Also, once a traditional owner requests a Roth IRA conversion, there is no “going back” to reverse the conversion. Prior to the passage of the Tax Cuts and Jobs Act in 2017 (TCJA), a traditional IRA owner who performed a Roth IRA conversion could recharacterize (reverse) the conversion. With a properly performed recharacterization, there is no conversion and therefore no tax due. But effective January 1,2018, recharacterizations are no longer permitted. Any negative consequences resulting from a Roth IRA conversion performed after December 31,2017 must now be dealt with.
Problem #2: Medicare Parts B and Part D IRMAA
When it comes to Medicare, the Medicare health care system is mostly funded by the federal government. Most Medicare Part B beneficiaries pay a standard monthly premium (during 2024 the standard monthly premium is $174.70). The standard monthly premium is increased by surcharges imposed on upper income individuals. In particular, those individuals with modified adjusted gross income (MAGI) exceeding certain MAGI thresholds or “income tiers.” The extra amount that higher-income individuals must pay is called an “Income Related Monthly Adjustment Amount” (IRMAA). Medicare determines IRMAA charges for a particular year based on MAGI reported on the federal income tax return from two years ago.
IRMAA surcharges are based on the MAGI “income tiers” and the surcharges apply on a “cliff” basis. Reaching the first dollar of an IRMAA “income tier” causes the full corresponding surcharge to apply to all annual premiums. The following example illustrates:
Example 1. During 2024, single federal tax filers with a 2022 MAGI of $103,000 or less pay no IRMAA charges. During 2024, married tax filers with a 2022 MAGI of $206,000 or less pay no IRMAA charges. Harold files as single. During 2022, Harold’s MAGI was $103,001, resulting in Harold paying an IRMAA surcharge of $69.90 during 2024 for his monthly Medicare Part B premium. The one dollar of additional income during 2022 has resulted in Harold paying during 2024 a total of $174.70 plus $69.90, or $244.60 per month (a total $2,935.20 during 2024) in Medicare Part B premiums.
IRMAA surcharges should be considered when performing a Roth IRA conversion. If they are not, then the income resulting from a Roth IRA conversion could result in a Medicare Part B beneficiary being pushed into a higher Medicare Part B “income tier,” and if applicable, Medicare Part D “income tier” also resulting in IRMAA surcharges. These surcharges are an example of a “stealth tax.” Due to the two-year lookback rule for MAGI, Roth IRA conversions performed starting at age 63 or older can increase IRMAA charges.
A suggestion to avoid current income “spikes” from a Roth IRA conversion is to consider making a series of partial small Roth IRA conversions over several years in order to avoid pushing income into a higher IRMAA “income tier” and federal/state marginal tax bracket.
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Problem #3: Underpayment of Estimated Income Taxes and Possible IRS Penalties
Federal (and state) estimated tax payments are usually paid in four equal installments spread over the calendar year (due on April 15, June 15, September 15 and the following January 15). An increase in income late in the year could result in an underpayment of estimated taxes for earlier quarters of the year.
It should be noted that for estimated purposes, a Roth IRA conversion performed in December is “deemed” income earned evenly throughout the year – not just in the fourth quarter of the year ending December 31st. If there is no other or a minimum federal income tax withholding, then as a result of a Roth IRA conversion performed in December, quarterly estimated tax payments would be due for all four quarters of the year. If the “income spike” resulting from a Roth IRA conversion performed in December is not accounted for, then a federal estimated tax underpayment penalty (currently 8 percent of the underpayment) could apply. Traditional IRA owners living in states with state and local income taxes also have to be concerned about underpayment penalties when it comes to Roth IRA conversions performed late in the calendar year.
In order to avoid the estimated tax penalty resulting from a Roth IRA conversion performed during December, the traditional IRA owner must be “proactive.” This is done when the individual files the federal income tax return for the year in which the Roth IRA conversion was performed. In particular, IRS Form 2210 (Underpayment of Estimated Tax by Individuals, Estates and Trusts) Schedule A1 (Annualized Income Installment Method). Filing Form 2210 Schedule A1 should eliminate the estimated tax penalty for the first three quarters. A copy of IRS Form 2210 Schedule A is shown here:
Since IRS Form 2210 Schedule A1 can be difficult to fill out, a traditional IRA owner who performs Roth IRA conversion is advised to get help from a tax professional.
Another option in order to avoid an underwithholding penalty resulting from a Roth IRA conversion performed in December is to take a distribution from another traditional IRA and request 100 percent withheld in federal income taxes. The withheld federal income taxes ae “deemed” to be paid equally over the year. This can level out any underpayments in previous quarters. The following example illustrates:
Example 2. Eilzabeth anticipates a total annual federal tax liability of $30,000. Because of that, Elizabeth pays a quarterly federal estimated tax of $7,500 during the first three quarters of the yar. In early December, Elizabeth does a Roth IRA conversion. The income from the conversion doubles Elizabeth’s total federal income tax liability for the year to $60,000. As a result, each of her first three quarterly estimated tax payments is $7,500 short.
In order to cover the shortfall, Elizabeth takes another distribution of $30,000 from her traditional IRA and requests that 100 percent ($30,000) be withheld in federal income taxes. The withheld taxes are “deemed” to be paid equally over all four quarters - $15,000 paid for each quarter. This increases the first three quarterly payments to $15,000 each which covers the additional taxes due on Elizabeth’s Roth IRA conversion in December.
Shortly after taking the extra $30,000 traditional IRA distribution, Elizabeth replaces the $30,000 with funds from her money market accounts via a 60-day IRA rollover. As a result of the successful traditional IRA rollover, the federal tax liability of $30,000 on the traditional IRA distribution is eliminated.
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Ed Zurndorfer, EA, ATA, CFP®, CLU®, ChFC®, CEBS®, ChFEBC℠: Federal Employee Benefits Expert
A former career Federal employee, Ed has published a staggering 1,200+ separate articles on Federal Benefits and Retirement!
Just “Google” his name, and you are likely to find a plethora of sites that contain his writings. Drawn to its mission to reach, teach
and serve Feds, Serving Those Who Serve is the only financial planning practice with which Ed has chosen to affiliate in over
20 years teaching. In addition to conducting Federal Benefits seminars for Serving Those Who Serve, you can find Ed’s
writings here on our blog in the FedZone, and on Fed-Soup, MyFederalRetirement, FederalNews Radio and NITP.
He is a member of the Maryland Society of Accountants, the National Association of Enrolled Agents, the International Society of Certified Employee Benefits Specialists, the Financial Planning Association, the National Association of Health Underwriters,
and the Society of Financial Service Professionals. Since 1999, Ed has taught many thousands of Federal employees about
their benefits, in person and at Federal agencies all over the country. Ed is a true national treasure.
Edward A. Zurndorfer is a CERTIFIED FINANCIAL PLANNER™ professional, Chartered Life Underwriter, Chartered Financial Consultant, Chartered Federal Employee Benefits Consultant, Certified Employees Benefits Specialist and IRS Enrolled Agent in Silver Spring, MD. Tax planning, Federal employee benefits, retirement and insurance consulting services offered through EZ Accounting and Financial Services, and EZ Federal Benefits Seminars, located at 833 Bromley Street - Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652. Raymond James is not affiliated with and does not endorse the opinions or services of Edward A. Zurndorfer or EZ Accounting and Financial Services. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.