Three Surprising Ways a Roth Conversion Can Hurt You

FROM WSJ.COM 

A Roth IRA conversion can be a valuable tax- and estate-planning tool for many folks. After converting money from your traditional IRA to a Roth IRA (under today’s law) you’ll never have to pay tax on that money again. Plus, you are never forced to withdraw the funds during your lifetime, leaving this tax-free money to your heirs if you wish.

However–it’s not always as simple as just figuring out the upfront tax cost of the conversion and calculating the years of returns until you break even. There can be surprise effects to a Roth conversion that you didn’t plan for.

Social Security taxation. If you’re receiving Social Security benefits and your other income is relatively low you may be paying tax on only a small portion of those benefits, if at all. Adding a Roth conversion to your taxable income can cause your Social Security benefits to be counted at up to 85¢ per dollar of benefits, which can result in a sizable, unexpected, increase in your income tax. This impact happens at relatively low levels of income–the maximum taxation of Social Security benefits occurs when half of your SS benefit plus your other income is greater than $44,000 for a married couple.

Medicare Part B premiums. Your Medicare Part B premium is based on your income level two years before the current year. For 2015, your 2013 Modified Adjusted Gross Income (MAGI) determines the amount of your Part B premium. For many folks this premium is $104.90 a month. But if your 2013 MAGI was greater than $85,000 ($170,000 for a married couple) the premium goes up, and can be as high as $335.70 a month, an increase of 220%. A Roth Conversion would certainly increase your MAGI; you need to be aware that the increase could have an effect on your Medicare premiums two years in the future. Your Part D (prescription drug plan) premium may also increase as a result of an increased income level.

Passive loss restrictions. For many folks who own rental real estate, the tax benefit of deducting losses on the activity can be very beneficial. With some level of participation in managing the property, you could deduct up to $25,000 worth of losses from your ordinary income, which can result in a significant tax savings. When your Modified Adjusted Gross Income (MAGI) is more than $100,000 this allowable deduction begins to reduce, and it goes away altogether when your MAGI is greater than $150,000. As mentioned above, a Roth Conversion will result in an increase to your MAGI, and if the Conversion is large enough, you will reduce or even eliminate the ability to deduct any passive losses for the year.

There are other effects of a Roth conversion including limitations on itemized deductions (plus medical deductions, charitable contributions, and miscellaneous deductions) and other aspects, but the above items prove to be the most surprising in my experience.