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The Roth IRA (Part 3 of 3)

This is the third article in our series covering the value of Roth IRAs. To read the first article click here. To read the second article click here.

In the first two weeks of our series, we laid out the value of the Roth IRA by addressing the potential for lifetime tax savings that you can enjoy by paying your tax bill now and getting money into the Roth today.

This week we are going to focus on how the Roth IRA can dramatically reduce the taxation of your social security and significantly reduce your healthcare costs in retirement.

The key to effectively using Roth conversions and contributions is in tax-efficiently lowering the amount of assets in Tax-Deferred accounts (Bucket 1) and shifting them into the Never-To-Be-Taxed-Again Accounts (Bucket 3). By lowering the amount of assets in Bucket 1, you avoid higher tax brackets, increased Social Security taxes and higher Medicare premiums in retirement.

For a refresher on the 3 types of buckets, read here. The objective of this strategy is to lower the Required Minimum Distributions that can result in higher marginal tax rates in retirement.

Social Security and Roth IRAs

William Reichenstein, emeritus professor of finance at Baylor University says, “I don’t think people understand how important this taxation of Social Security really is.” The two factors that Reichenstein points to are the higher marginal tax rates and higher Medicare premiums.

Marginal tax rates refer to the tax rate you pay on each dollar of income. For working taxpayers, this is often a straightforward calculation. If you are married and earn an Adjusted Gross Income (AGI) of $100,000, your marginal tax rate is 22%. This means that the next $1,000 of income creates $220 of income tax due.

Unfortunately, this is not the case for retirees receiving Social Security benefits. That’s because the taxation on Social Security benefits creates a “tax bubble,” and this tax bubble creates additional income tax beyond the marginal tax bracket.

For example, consider John and Jane Smith. John and Jane have an income of $44,000 and receive combined Social Security benefits of $24,000. Based on the rules for determining taxable SS benefits, John and Jane Smith are only taxed on $16,200 of their Social Security benefits. Combining their $44,000 of income with $16,200 of taxable social security benefits brings their Adjusted Gross Income to $60,200.

If John and Jane Smith decide to pull out an additional $1,000 of income from their retirement accounts to fund an extra vacation, their Adjusted Gross Income will increase by $1,850, due to the increased taxation on their Social Security benefits. Even though they are technically in the 15% tax bracket, their tax bill will increase by $277.50, meaning their marginal tax rate on the extra $1,000 will be 28%.

By making a series of partial Roth conversions, John and Jane can avoid being put into a higher effective marginal tax bracket. Other couples with higher retirement incomes may also avoid paying higher Medicare premiums in retirement by applying this strategy.

Medicare Premiums and Roth IRAs

As for the Medicare premiums, we discussed these in further detail last September, which you can read here. The key point is that higher retirement incomes create much larger Medicare premiums. That’s because the government assumes you have the resources to pay more for your health insurance.

In the chart below we summarize the additional Medicare premiums you will face if your Modified Adjusted Gross Income rises above $91,000.

Tax Burden After Death

An additional consideration is what happens after one spouse dies. In the first year following the death of a spouse, the widowed spouse will be filing an individual tax return. And single filer tax brackets are much higher than married couples who file jointly. And three calendar years after the spouse’s death, that same widow may be paying much higher Medicare premiums.

If a spouse passes away in 2022, the widow will be forced into the singles brackets in 2023 if they don’t remarry. That means their standard deduction will be cut in half while their AGI may be only slightly lower than what it was before the spouse died. That’s because the widow may experience only a small loss of income due to the death of their spouse. When that happens, that same widower could see their individual annual Medicare premium be higher than the prior Medicare premiums for both spouses.

What does that mean? One spouse dies... Surviving spouse income drops... Total cost of health care for the surviving spouse could be higher than when both spouses were alive!

The Solution

The rising costs of taxes combined with the exponentially rising costs of health care are two compelling reasons to consider the Roth IRA for conversions or future contributions.

While the Roth option is not the right solution for every investor, it is worth discussing with a trusted advisor to determine if it is the right solution for you.

To speak with a trusted advisor and find out how we can help you, click the button below.

This article is a general communication being provided for informational and educational purposes only and is not meant to be taken as tax advice, investment advice or a recommendation for any specific investment product or strategy. The information contained herein does not take your financial situation, investment objective or risk tolerance into consideration. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. Any examples are hypothetical and for illustration purposes only. All investments involve risk and can lose value, the market value and income from investments may fluctuate in amounts greater than the market. All information discussed herein is current only as of the date of publication and is subject to change at any time without notice. Forecasts may not be realized due to a multitude of factors, including but not limited to, changes in economic conditions, corporate profitability, geopolitical conditions, inflation or US tax policy. This material has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed.

LEGAL, INVESTMENT AND TAX NOTICE. This information is not intended to be and should not be treated as legal, investment, accounting or tax advice.


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