When roth IRA conversions aren't tax friendly

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Tax-free Roth IRA distributions can be a valued source of retirement income; withdrawals are completely untaxed after age 59-1/2, assuming the account is at least five years old. However, building up a Roth IRA recently hit a snag.

“For some clients, dealing with the Affordable Care Act (ACA) exchanges adds another dimension to Roth IRA conversions,” says Marty James, a CPA/PFS who heads an investment and tax management firm in Mooresville, Ind. “Lost health insurance tax credits can increase the effective cost of the conversion.”

A Roth IRA conversion creates more taxable income. Higher income, in turn, might cost certain clients health insurance discounts, adding sharply to the premiums they’ll have to pay.

James tells of a married couple who executed a $40,000 Roth IRA conversion earlier this year. “We calculated they could convert that much and stay in the 15% tax bracket,” he says. That bracket goes up to $73,800 of taxable income (after deductions) for a couple filing jointly in 2014.


These clients, though, recently stopped working and no longer have employer-provided health insurance. They’re buying their own coverage through an ACA exchange so they would be eligible for health insurance premium tax credits, with their income. Currently, some tax credits are allowed with modified adjusted gross income (MAGI) up to $45,960 for a single person. Larger households have higher MAGI thresholds for the tax credits, up to $126,360 for a family of six. (Generally, MAGI for this purpose is basic AGI plus any tax-exempt Social Security, interest, or foreign income.)

“After executing the $40,000 Roth IRA conversion, and adding $40,000 to their income this year, this couple would have lost $8,000 in health insurance tax credits,” says Kyle James, another CPA/PFS at the firm. While their federal income tax on the conversion would have been $6,000—15% of $40,000—the added $8,000 from lost health insurance tax credits would have more than doubled the effective tax bill, to $14,000. These clients don’t want to lose the tax credits, according to Marty James, so they’ll do something by year-end.


One possibility is recharacterizing the $40,000 Roth IRA conversion back to a traditional IRA. That will wipe out any increase in health insurance costs caused by higher income. “We’ll also look at investing in an oil and gas program that provides first-year deductions, to offset some of the increased income,” says Marty James. In any case, it’s likely that this couple will postpone or sharply reduce Roth IRA conversions until they reach age 65 and become eligible for Medicare.

Then they won’t be buying health insurance on an ACA exchange so the health insurance premium tax credits won’t be an issue.

Under the ACA, many people may be able to receive substantial health insurance tax credits. Advisors now should weigh the effective tax cost of a Roth IRA conversion for such clients.

Additionally, recent court rulings have created some uncertainty about ACA health insurance tax credits. “It’s time to proceed with caution before undoing a Roth IRA conversion." James says.

"Fortunately, with Roth IRA conversions, taxpayers have a long time (until October 15 of the following year) before the decision is final.”]

Donald Jay Korn is a Financial Planning contributing writer in New York. He also writes regularly for On Wall Street.

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