Roth IRAs have gotten much attention in the financial media over the last few years. The idea of receiving tax-free income in retirement via Roth IRAs has attracted many individuals including federal employees and retirees.
However, there is a restriction in order for an individual to contribute to a Roth IRA. The restriction is that the individual’s annual modified adjusted gross income (MAGI) must be below certain limits. These limits are announced annually by the IRS. The 2024 Roth IRA MAGI contribution limits are shown here:
Roth IRA Income Requirements for 2024
However, there is another way that individuals can get and add to a Roth IRA, regardless of their MAGI. It is by means of a Roth IRA conversion. In a Roth IRA conversion, a traditional IRA owner converts his or her traditional IRA to a Roth IRA. Federal and state income taxes are due in the year a Roth IRA conversion is performed.
Federal employees and retirees who are interested in performing Roth IRA conversions are advised to be aware of the common mistakes that traditional IRA owners sometimes make when performing Roth IRA conversions. Five of the most common mistakes are discussed.
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Mistake #1: Possible Loss of Valuable Income Tax Credits and Income Tax Deductions Due to Increased Adjusted Gross Income
A Roth IRA conversion is fully taxable for most individuals and therefore the conversion results in an increase in the converted Roth IRA owner’s adjusted gross income (AGI) in the year of conversion. The increased AGI can result in the converted Roth IRA owner’s loss of valuable federal and state income tax credits and income tax deductions and increased “stealth taxes” such as the net investment income tax (NIIT). The NIIT is equal to 3.8 percent and is imposed on investment income (interest, dividends, capital gains) in addition to the regular federal income tax imposed on the investment income.
Traditional IRA owners should be aware that once an order is placed to convert a traditional IRA to a Roth IRA, there is no “going back.” Prior to the passage of the Tax Cuts and Jobs Act of 2017, it was possible to rescind the Roth IRA conversion via a “recharacterization” (thereby reversing the conversion). This “no going back” is especially important when a Roth IRA conversion is performed in mid- to late December. An end-of-year surge of income could result in the converted Roth IRA owner’s being pushed into a higher marginal tax bracket for that year.
Mistake #2: Increased AGI from a Roth IRA Conversion and Possible Higher Medicare Part B “Income Tier”
An individual enrolled in Medicare Part B (medical insurance) pays a monthly premium. The amount of the Medicare Part B beneficiary’s monthly premium depends on the beneficiary’s modified adjusted gross income (MAGI). The higher the MAGI, the higher the monthly premium. There is a standard monthly premium, called the “first income tier” monthly premium for Medicare Part B beneficiaries. For example, the “first income tier” monthly premium during 2024 is $174.70. The standard monthly premium is increased by surcharges imposed on upper-income individuals; in particular, those individuals with MAGI exceeding certain thresholds. The extra monthly premium amount is called an “Income Related Monthly Adjustment Amount (IRMAA).” When the first dollar of an IRMAA level is reached, the result is that the corresponding IRMAA surcharge is applied to all monthly premiums for that year. The increase in AGI resulting from a Roth IRA conversion could cause the Medicare Part B beneficiary to be pushed into a higher “income tier.” Note that the Center for Medicare and Medicaid Services (CMS) determines IRMAA charges for a particular year based on the MAGI reported on the Medicare Part B beneficiary’s federal income tax return from two years ago. For example, 2025 Medicare Part B monthly premiums will be based on a Medicare Part B beneficiary’s 2023 MAGI.
Mistake #3: Individuals Who Lack “Liquid” Assets Should Not Perform Roth IRA Conversions
A Roth IRA conversion is a taxable event. Federal and state income taxes must be paid in full in the year of conversion on the amount converted. No federal and state income taxes are withheld by the IRA conversion custodian when the traditional IRA is converted. The converted Roth IRA owner is responsible for paying the federal and state income taxes due on conversions. The payment of the taxes due is usually done through a quarterly federal and state estimated tax payment. If the converted Roth IRA owner does not have a sufficient amount of liquid assets (for example, in a passbook savings or a money market account) to pay the taxes due, then the traditional owner is advised not to perform a Roth IRA conversion.
Mistake #4: Traditional IRA Owners with Charities as Designated Beneficiaries Should Not Convert
Traditional IRA owners who have designated charitable organizations like Houses of Worship as their beneficiaries are advised not to convert to Roth IRAs. Charities are not subject to federal and state income taxes. Because of that, it therefore does not make sense for a traditional IRA owner to pay the taxes due on a Roth IRA conversion while naming a charitable organization as the converted Roth IRA beneficiary. The result would be to leave a tax-free bequest to an entity that does not pay income taxes.
Mistake #5. A Traditional IRA Owners Assume They Will Be in a Lower Marginal Tax Bracket
Those traditional IRA owners who believe that they will be in a lower federal and state combined marginal tax bracket in retirement should reconsider a Roth IRA conversion. Converting today in a higher federal and state combined marginal tax bracket, when in fact the traditional IRA owner expects to be during retirement in a lower combined marginal tax bracket, does not make financial sense.
In short, there are five key questions a traditional IRA owner needs to ask before executing a Roth IRA conversion. They are: (1) Will there be a sufficient amount of liquid assets will be available to pay the federal and state income taxes due on the Roth IRA conversion?; (2) What will the converted Roth IRA owner’s combined marginal tax bracket be in retirement – higher or lower?; (3) What impact will the additional income resulting from the conversion have on current year federal and state income tax credits and deductions?; and (4) Who will be the Roth IRA beneficiary – a tax paying entity or a tax-exempt entity?