Introduction
Medicare is federally provided health insurance for Americans 65 and older. Premiums for Part B and D are subject to certain income surcharges depending on your modified adjusted gross income (MAGI), called the income related monthly adjustment amount (IRMAA). Depending on your tax filing status, there are certain income thresholds that determine if you will have to pay this surcharge on top of the typical Part B and D premiums. Income planning is an important strategy to manage MAGI and, thus, reduce or avoid these penalties. One common strategy is to pair Roth conversions with annuities. This article aims to provide guidance on this income optimizing strategy. Note: This is only a guideline, please consult with a financial/retirement advisor on an income planning strategy that fits your circumstances.
Income and MAGI
You will not find a line item on your tax return labeled MAGI. MAGI is a total of the following:
Adjusted Gross Income (AGI) on federal tax return (IRS Form 1040, Line 11)
Excluded foreign income
Nontaxable Social Security benefits (including tier 1 railroad retirement benefits)
Tax-exempt interest
Withdrawals from retirement savings accounts such as 401k’s and IRAs are considered normal income and included in your AGI. These accounts become more of a factor in terms of IRMAA when a beneficiary reaches the age for Required Minimum Distributions (RMDs). Reducing RMDs starts years before a beneficiary reaches age 72 (or 73).
What is a Roth Conversion?
In short, a Roth conversion is a transfer of funds from a traditional retirement account into a Roth IRA (Kagan, 2024). There are several ways to transfer funds from a 401k or IRA to a Roth IRA. But what’s important is the result: tax free AND RMD free income later in retirement. This is because withdrawals from a Roth IRA are not taxed (you pay the taxes up front during conversion) and there are no RMDs for Roth accounts.
Roth Conversions and Non-Qualified Annuities
This brings us back to annuities and how to incorporate these conversions into an income plan. Money that is converted from a traditional account to a Roth account must stay in the Roth account at least five years prior to withdrawal. Otherwise, you will have to pay a 10% penalty.
The five-year gap between funding the Roth IRA and being able to withdraw the funds may not be an issue for some beneficiaries. However, if you need to bridge the gap, this is an opportunity where the right kind of annuity can play a role.
A non-qualified annuity is an annuity funded with after-tax dollars that defers taxes on interest into the future. This means that when you withdraw funds from an annuity, the principal withdrawn is not taxed, only the interest earned. This contrasts with funds from a traditional retirement savings account that is considered normal income in the year they are withdrawn. Funds from a non-qualified annuity may have a lower tax burden, thus, decreasing your MAGI and any associated IRMAA surcharges (if applicable).
Qualified Longevity Annuity Contract
In 2014, the U.S. Treasury Department sanctioned the rules allowing IRA owners and qualified plan participants to buy qualified longevity annuity contracts or QLACs. This rule allows retirees to use a portion of their qualified accounts (like a traditional IRA or 401k) to buy a deferred income annuity and have the RMDs move from 72 (or 73) to 85. This can have several benefits:
If you are unable to convert a sizable portion of your traditional accounts to Roth’s for some reason, you can still push the RMDs out for funds up to $200,000 (recently updated by the SECURE 2.0 Act).
Since RMD amounts are calculated on the amount of money you have in your traditional accounts, you can lower the RMD by moving up to $200,000 into a QLAC. This reduces your MAGI after RMDs kick in.
Conclusion
The discussion above is a generalized guideline on how annuities and Roth conversions can be coupled to help reduce or avoid IRMAA surcharges. The more moving parts and streams of income you have, not to mention the unpredictability of life in general, the more complicated income planning and execution can become. Thankfully, there are many trusted and qualified advisors available to aid you on your journey to retirement. Optimizing your retirement income and enjoying retirement are certainly possible!