When IRA Conversions Don’t Add Up

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If you're just skimming financial headlines, you might be inclined to order up a Roth IRA conversion--stat! "Now Is the Best Time in History to Do a Roth Conversion," read the headline in one publication. "Now Is the Perfect Time to Convert Your IRA to Roth," answered another.

It's true that there's a lot about the current environment that points to the advantages of converting traditional IRA assets to Roth--depressed balances (at least somewhat depressed; they've recovered a lot), temporarily low tax brackets for some investors, and tax rates that are low relative to historical norms.

But at the same time, investors barreling into conversions without doing some analysis may run into some nasty surprises. Unless you’re extremely conversant in tax matters, this is one area to get some tax advice before proceeding. For one thing, conversions will almost always result in a bigger tax bill, so you have to know how you’ll pay those taxes when they come due next year. (As Pimco’s Tim Steffen notes, it’s wise to pay the taxes with non-IRA assets rather than having to withdraw extra from the IRA to do so.) In addition, while in the past conversions could be “undone” with a recharacterization (a “do-over” after a conversion), recharacterizations are no longer allowable thanks to the Tax Cuts and Jobs Act that Congress passed toward the end of 2017. That means if you make a conversion that costs you more in taxes than you expected or otherwise turns out to be ill-advised, you’ll have to live with the consequences.

Why? And Why Now? There are two key advantages of converting traditional IRA assets to Roth. The first is the ability to take tax-free withdrawals from the account in retirement, or for your heirs to do so if you don't consume the whole IRA during your lifetime. The second is to skip required minimum distributions on your IRA assets; traditional IRAs are subject to RMDs once you pass age 72, whereas Roth IRAs don't carry RMDs. There's been discussion about "harmonizing" the RMD rules between traditional and Roth accounts for years, but for now, the advantage goes to the Roth. Not having to take RMDs buys extra flexibility around tax planning and is particularly advantageous for wealthy retirees who plan to leave assets to children and grandchildren.

As great as those advantages are, they don't come without a cost: At the time of conversion, you'll owe taxes on any portion of the converted amount that you haven't already paid taxes on--pretax or tax-deductible contributions plus any investing earnings that have accrued on those contributions. To use a simple example, let's say my traditional IRA balance consists exclusively of money I rolled over from an old 401(k), so my balance is exclusively pretax contributions plus investment earnings. In that case, any amount that I converted would be 100% taxable.

That tax treatment is what it is, but there are a few aspects of the current environment that point to the virtue of converting. One is that stocks slid in the first quarter; while they've recovered nicely, many IRA account balances are still down for the year, especially for more aggressively positioned IRAs.

Moreover, some investors may find themselves in a temporarily low tax bracket in 2020, meaning the tax bill on their conversions will be lower. Thanks to the passage of the CARES Act in March, investors with IRAs that would otherwise be subject to RMDs don't have to take those distributions. That means that many retirees will find themselves in a lower tax bracket than in years past. Working individuals may also find themselves in a lower tax bracket because of unemployment or reduced income. Of course, it's an open question whether they'd want to embark on a conversion and fork over the extra taxes at this time. But if they do, they'd potentially be able to pay less in taxes than they would in a more flush year.

Finally, it's not unreasonable to consider tax rates secularly--where they are today versus where they might go in the future. While the Tax Cuts and Jobs Act reduced taxes for many taxpayers, albeit with more limits around deductions like state and local taxes, the amount of stimulus needed to kick the economy back into gear could force tax rates back up in the future.

Unintended Consequences So, those are all the good reasons to consider a conversion, or at least phone your CPA or financial advisor for his or her advice. But conversions also have the potential to lead to some unintended consequences, such as the following:

The "Cream in the Coffee Rule" As noted above, the taxes due on many conversions will be straightforward: If the money has never been taxed before (the balance consists of pretax contributions plus investment earnings on those contributions), ordinary income tax rates will apply to any converted amounts. By the same token, if my whole IRA consists of money that I've already paid taxes on--for example, I made nondeductible contributions and haven't made any investment gains on them--then any converted amounts are tax-free. (That's the thesis behind the "backdoor Roth IRA"--funding a traditional nondeductible IRA then converting it before it makes any investment gains.)

But what if my IRA is a combination platter--deductible/pretax contributions, nondeductible contributions, and investment gains? In that case, I don't have the latitude to convert only those accounts that consist at least in part of money I've already paid taxes on and therefore would be subject to less tax. That's because the "pro rata" rule comes into play. That means the taxes due on any converted amounts are based on the ratio of monies in all of my IRA accounts that have never been taxed relative to those that have been taxed. If 70% of my total IRA balance balance has never been taxed, for example, then 70% of the amount of my conversion will be taxable. The pro rata rule is sometimes called "the cream in the coffee" rule to reflect that nondeductible IRA contributions are inextricably linked to pretax/deductible ones; once you've got both types, there's no separating them. Even if you convert a brand-new IRA consisting strictly of aftertax contributions (because you're doing a "backdoor Roth," for example), your taxes due upon that conversion will depend on the tax makeup of all of your IRA investments.

IRMAA Another issue related to conversions, especially for wealthier retirees or people who make a large conversion in a single year, is the potential for Medicare surcharges--the income-related monthly adjusted amount, or IRMAA. As Morningstar contributor Mark Miller notes, IRMAA affects about 7% of Medicare-eligible taxpayers. For 2020, IRMAA applies to single filers with a modified adjusted gross income above $87,000, and double that figure ($174,000) for joint filers; the surcharges scale up depending on which bracket your modified adjusted gross income falls into. At the highest level (incomes of $500,000 or above), an individual taxpayer could pay nearly $4,200 more per year than someone who's not subject to the surcharge.

There are a few oddities related to IRMAA worth noting. First, having even one dollar extra of income can bump you into the next-highest IRMAA amount. For example, an individual filer with an income of $136,000 would pay $2,429 per year in Medicare Part B premiums, whereas a person with an income of $136,001 would pay $3,470. Moreover, whether IRMAA applies in a given year depends on the most recent tax return made available by the IRS to the Social Security Administration. That essentially means that whether IRMAA applies is subject to a two-year lag. For example, whether you pay IRMAA in 2020 would depend on the modified adjusted gross income reported on your 2018 tax return.

Because a large conversion can cause income to spike and increase the likelihood you'll be subject to IRMAA in the future (2020 conversions would affect whether you're subject to IRMAA in 2022), it's worth considering these Medicare surcharges alongside other variables when deciding whether to move forward with a conversion.

Of course, the conversion and specifically the fact that the retiree who has converted can take tax-free withdrawals and/or skip RMDs also has the potential to reduce the effects of IRMAA over time, even if IRMAA comes into play for the year of the conversion. Indeed, reducing the effects of IRMAA overall can be a reason to consider a conversion, not just avoid one. That accentuates the value of getting some professional advice before proceeding with a conversion, especially a large one.