Married couples could significantly lower their joint lifetime income taxes and may reduce their joint lifetime Medicare premiums by doing Roth conversions while both are alive, an expert on Social Security benefits issues said.
The basic idea is to use Roth conversions to lower assets in tax-deferred accounts, thereby avoiding higher tax brackets and increased Social Security taxes and Medicare premiums later in retirement. A key to the strategy is to lower required minimum distributions that can result in higher marginal tax rates.
“I don’t think people understand how important this taxation of Social Security really is,” said William Reichenstein, head of research for retiree income at Social Security Solutions, which offers platforms designed to help advisors and near retirees to map retirement strategies.
High marginal tax rates (MTR) or the tax rate you pay on an additional dollar of income, and the Medicare Income-Related Monthly Adjustment Amount (IRMAA), or spikes in annual Medicare premiums, are the culprits, Reichenstein noted. But he said by making a series of partial Roth conversions while both partners are alive, they can avoid being put in a higher tax bracket and paying higher monthly Medicare premiums.
IRMAA is an amount you may pay in addition to your Part B or Part D premium if your income is above a certain level. The Social Security Administration sets four income brackets that determine the IRMAA for single filers and married couples.
Reichenstein, emeritus professor of finance at Baylor University, explained that the first year following the death of a spouse, the widow will face tax brackets for singles, which are higher than those for a married couple filing jointly. Also, three calendar years after his death, the widow may pay larger Medicare premiums.
So, if the spouse died in 2019, the widow in 2020 would be forced into the singles brackets, if she does not remarry, and her standard deduction would be decidedly lower, Reichenstein noted. Further, he explained that if the widow and the late spouse were the same age of at least 65, her adjusted gross income (AGI) will likely be only slightly lower than what it was before the spouse died because she would only now collect the higher of the two Social Security benefits. In most cases, he said, her AGI would consist primarily of required minimum distributions (RMDs) from tax-deferred accounts (TDAs), like a 401(k), the taxable amount of Social Security benefits, any interest or capital gains they would have gotten on assets, and pension benefits, when applicable.
For example, Reichenstein presumed that if both partners were alive with a modified adjusted gross income (MAGI) of $181,000, their 2022 taxable income would be $152,300 ($181,000 and a standard deduction of $28,700) and their federal income taxes would be $24,740. Upon becoming a widow, he assumed her AGI and MAGI would be $171,000 because of her losing the smaller of their Social Security benefits. In this case, after deducting her standard deduction of $14,700, her 2022 taxable income would be $156,300 and her federal income taxes would be $31,347.50, he noted. “In short, she would pay $6,607.50 more in federal income tax as a single individual than they would have jointly paid if both partners were still alive. If she lives in a state that imposes an income tax, then the difference would be larger.” Reichenstein said.
As for the annual Medicare premiums, using the same MAGI, both spouses, if they were alive, would each pay $170.10 per month in Medicare Part B premiums in 2022 for total annual premiums of $4,082.40 ($170.10 x 24 months). For a widow, 2022 monthly Medicare premiums would be $544.30 ($170.10 standard premium + $374.20 of IRMAA) for an annual Medicare premium of $6,531.60 (12 months x $544.30). For a couple, their MAGI would be $181,000, meaning they would each pay $170.10 per month for a joint annual premium of $4,082.40. The widow’s annual Medicare premium of $6,531.60, Reichenstein noted, is $2,449.20 more than their annual joint Medicare premiums would have been if both partners were still alive.
In this case, Reichenstein pointed out, by making a partial Roth conversion while both partners are alive, the couple pays 22% on additional income this year. “This strategy is better than not making the partial Roth conversion and the widow having to pay federal income taxes of 24% on the TDA withdrawal later in life,” he said. “In addition, by making the partial Roth conversion, while both partners are alive, they can greatly reduce their joint lifetime Medicare premiums, because the partial Roth conversions may greatly reduce her Medicare premiums beginning three calendar years after the death of the first spouse.”