I have long touted the benefits of diversifying a client's assets when creating and implementing a retirement income plan. Having the ability to draw down assets that carry varying tax characteristics (e.g., if the assets are taxed as ordinary or capital gain income, are tax exempt or are tax free) allows the client an income stream while mitigating the tax impact of that income.
When solely taking distributions from pretax retirement vehicles, a client is subject to ordinary income, which is taxed at his or her marginal tax rate. One strategy that many advisors recommend, and for good planning reasons, is a Roth conversion. In low-income years in particular, it can help clients move toward tax diversification. But before you decide to recommend a conversion to a client who is in or near retirement, you need to be aware of a potential side effect.
How Roth Conversions, and an Overlooked Consequence
A Roth conversion is a relatively easy strategy to understand and implement. An IRA owner can convert all or a portion of a traditional IRA to a Roth IRA by submitting a short and simple form to the IRA custodian. The amount converted is taxable as ordinary income in the year of conversion. Assuming that the requirements of the 5fiveyear rule are met, the funds in the Roth IRA will be tax free upon distribution. Seems rather simple, right?
Although converting to a Roth IRA may be a very smart move for the right client, I have often found that advisors miss one unintended consequence of this decision when working with clients who are nearing retirement. The client is certainly likely to anticipate the tax consequences of the conversion, but he or she seldom expects that the higher income brought about by the conversion can lead to an increase in his or her Medicare Part B monthly premiums.
Why the Increase in Medicare Part B Premiums?
Medicare Part B covers services considered medically necessary to treat a disease or condition, including doctors' services, outpatient care, some home health care, and more. Premiums for Part B vary, based on the insured's Medicare income. If the insured's income, which includes adjusted gross and tax-exempt monies, exceeds certain thresholds, his or her monthly Part B premiums can rise significantly.
