I’d like to offer a different perspective on Roth conversion costs and rates, particularly for people with multiple forms of taxable income and more complex returns.
Roth conversions have wide ranging effects on tax returns and Medicare premiums, including:
1) Ordinary income taxes – Conversion income increases ordinary income which bumps your total ordinary income into higher tax brackets and may cause itemized deductions to be phased-out (e.g., medical expenses).
2) Qualified dividends and LT capital gains taxes – The preferential tax rate on qualified dividends and capital gains is based on total taxable income. Conversion income may push the preferential rate from 0% to 15% or from 15% to 20%, which could cause qualified dividend and capital gains income to be taxed at higher rates.
3) 3.8% Net Investment Income Tax (NIIT) – Conversion income may push AGI over the $250,000 NIIT threshold which could cause additional taxes on investment income.
4) Medicare Part B and D premiums – Medicare premiums are based on a recipient’s modified adjusted gross income (MAGI). Conversion income may push MAGI over various Medicare thresholds thereby triggering additional Medicare premiums. These premiums are known as Income Related Monthly Adjustment Amounts or “IRMAA.”
The best way to estimate the total tax cost of a Roth conversion is to calculate its marginal tax cost. This calculation requires making a “before” and “after” calculation as follows:
1) Calculate your income taxes and Medicare premiums before Roth conversion income.
2) Calculate your income taxes and Medicare premiums after Roth conversion income.
3) The difference is your total marginal tax cost of a Roth conversion.
To calculate your marginal tax rate on a conversion, divide the total tax cost from step 3 above by the Roth conversion amount. For example, if you do a $100,000 Roth conversion and your marginal tax cost is $25,000, then your marginal tax rate would be 25%.
Also, you should include state income taxes, if any, in the before and after calculation.