A Roth Conversion Boosts Medicare Costs

Medicare beneficiaries who convert to a Roth IRA should plan for an unexpected cost: higher Part B premiums.

EDITOR'S NOTE: This article was published in the January 2010 issue of Kiplinger's Retirement Report. To subscribe, click here.

Medicare beneficiaries who convert a traditional IRA to a Roth should plan for an unexpected cost: higher Part B premiums. If the conversion pushes your taxable income above a certain threshold, you'll pay an income-adjusted surcharge on Medicare premiums for a year or two.

A lot of attention is being paid to the fact that if you convert to a Roth in 2010, when the $100,000 income limit for conversions disappears, you'll have to pay income tax on the amount you convert. In 2010 only, you can delay reporting the conversion for one year, and then split the converted amount in half on your 2011 and 2012 returns, paying part of the tax in 2012 and part in 2013.

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Less well-known is that the new conversion rules are running headlong into means-testing for Medicare beneficiaries. Since 2007, the Part B premium is calculated based on adjusted gross income. The 2010 premiums are based on taxable income in 2008. Income added as a result of a Roth conversion will be cranked into the Medicare Part B calculation.

Here's how it works. Let's say Mr. and Mrs. Green convert $500,000 in 2010. If they pay the entire tax bill in 2010, their Part B premium in 2012 would be at least $353.60 for each spouse each month -- a total of $8,486.40 for the year. That would compare with $2,313.60 the couple would pay if they didn't convert and paid the $96.40 monthly premium. (These calculations are based on the 2010 premiums; the 2012 premiums have not been determined yet.)

The higher premium would only be for one year. If the Greens' income returns to its preconversion level in 2011, the Social Security Administration would readjust the Part B premium downward for 2013.

Let's say Mr. and Mrs. Black took the delay-and-split route on their Roth conversion. They would convert the $500,000 in 2010. They would report $250,000 of income in 2011 and $250,000 in 2012.

In this case, the Blacks would then pay a higher Part B premium in 2013 and 2014. Because their income each year would be between $214,001 and $320,000, they each would pay a monthly premium of $221 -- a total of $5,304 a year.

The prospect of paying higher Part B premiums for a year is not likely to discourage F. Earl Morrison, 66, from converting about $200,000 in 2010. The size of the conversion, plus other taxable income, would require that he and his wife, Arlene, each pay a Part B premium of at least $287.30 a month in 2012.

Morrison has two possible goals for the conversion. The couple could use the converted amount in late retirement, after years of compounded tax-free growth recoups the tax hit in 2010. The Roth could also be left as a tax-free nest egg for their children.

Morrison figures that income-tax rates may rise in 2011, when President Bush's tax cuts are set to expire. If he's right, and he defers the conversion and splits the tax bill over 2011 and 2012, then his tax bill will be higher. "I think I will go ahead and pay taxes in 2010 and take a one-year hit on the Medicare Part B premium," says Morrison, a retired federal government auditor who lives in Clermont, Fla. "When faced with not-perfect information, you have to synthesize it the best you can."

Mark Luscombe, principal analyst for CCH, a provider of tax information, offers another twist, noting that not converting to a Roth could push up premiums for years to come. Why? Because payouts from a traditional IRA -- required once you reach age 70 1/2 -- are taxable income for purposes of the Medicare surcharge. After you take the hit in the year (or years) you report the Roth conversion income, any withdrawals from the Roth are tax-free.

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Susan B. Garland
Contributing Editor, Kiplinger's Retirement Report
Susan Garland is the former editor of Kiplinger's Retirement Report, a personal finance publication whose subscribers are retirees and those approaching retirement. Before joining Kiplinger in 2006, Garland was a freelance writer whose work appeared in the New York Times, the Washington Post, BusinessWeek, Modern Maturity (now AARP The Magazine), Fortune Small Business and other publications. For 12 years, Garland was a Washington-based correspondent for BusinessWeek, covering the White House, national politics, social policy and legal affairs. Garland is a graduate of Colgate University.