Medicare Trap Triggered by Roth Conversion

I recently answered a sixty-six-year-old reader’s question about the tax impact of converting his IRA to a Roth IRA.  I pointed out that the dollars converted would be treated as ordinary income in the year of conversion and that he should make certain that he had money ‘outside’ his IRA to pay the taxes so that he could get 100% of the converted money into his Roth.  A reader pointed out yet another potential pitfall that should be considered.

“If the conversion amount is substantial there can or will be a major impact on the Medicare premium that may last for more than one year.  We missed this specific point on our conversion in the 2010 “grace” period (two year split) and it cost us about $11,000 the ensuing two years in premium increases – a very unpleasant surprise and one that we had never seen mentioned in all the research we pursued.”  D.P.

This reader is correct and it points out why it’s so important to get professional advice before making large financial decisions.  Here are some additional thoughts from one of my partners, Kimberly Reynolds, CFP, MS. “Part B and Part D premiums are income adjusted.  It is based on your tax return from 2 years ago. For example, the 2015 premiums are based on 2013 tax return.  The adjustment is based on your modified adjusted gross income which is a total of your adjusted gross income and tax-exempt interest income.  Income items such as capital gains and Roth conversions are counted and NOT excluded from the calculation.  So if you have significant income in one year then you will have to pay the income adjusted premiums in the following year.   If your income has gone down or changed due to certain situations such as divorce, death or retirement, then Social Security will reconsider and adjust the premium lower if appropriate.”

Reader Question:   My daughter & son-in-law are expecting their first child early next year and she would like to stop working for a few years to stay at home with the baby until he gets older.  The problem is, when they purchased their home almost 3 years ago, they financed it for only 15 years in hopes of paying it off sooner, and they don’t think that they can continue to make such large mortgage payments ($1800 with taxes & insurance) on only one income.  They have about $50,000 saved up, and are wondering what the best solution would be to lower their mortgage payment.  Should they pay down the principal & refinance for another 15 years again on the lower principal amount?  Or, should they use the $50,000 savings to make the original higher mortgage payments until she returns to work?  Their current mortgage balance is $169,000 at 3% with 12 years & 8 months remaining on the original loan.  L.A.

Answer:  First, congratulations on being a grandmother!  At 3%, they have a great interest rate on a 15-year mortgage.  Using some of their savings to pay down and refinance using a new 15-year mortgage would have the twin negative effect of significantly reducing savings (emergency reserves) and paying more interest over the life of the loan (due to refinance costs and an extension of the payment period).  My vote is to use the savings to help with the existing mortgage.  As your son-in-law receives a raise or bonus from his employer, he can replenish at least a portion of the savings until such time as your daughter returns to work.

Reader Question:  When one’s personal home is sold, what part of the proceeds are exempt from taxation for singles or married couples?  D.D.

Answer:  For couples, the first $500,000 of profit is tax exempt.  For singles, the tax exempt amount is $250,000.  You have to have owned and lived in the home as your primary residence for two out of the previous five years to qualify for the exemption.