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Can I Do a Partial Roth Conversion?

Quick housekeeping note: My wife and I are on vacation for the next couple of weeks, so there will be a gap in the publishing schedule. The next article will be published on Friday 5/8.

A reader writes in, asking:

“On several occasions, you’ve explained Roth conversions with language that indicates you can convert parts of your traditional IRAs to a Roth over time, for a variety of reasons.

When I looked into doing this several years ago, I encountered the rule that required you to value ALL your traditional IRAs and pay the tax on the full value of all of them converted.  I decided against it because that didn’t make sense to me (why would I convert only part when I have to pay tax as if I converted all of them).

Did I misunderstand the rules?  Is there something else I am missing?  I see so little reference to this anywhere.”

Yes, you can do a partial conversion. And in no case will you have to pay tax on more than the amount converted. To be more specific:

  • If your traditional IRA(s) do not contain any amounts from nondeductible contributions, the amount of the conversion will be included in your taxable income for the year, and
  • If you do have amounts from nondeductible contributions in your traditional IRA(s), a portion of the conversion will be included in your taxable income.

Most likely, the misunderstanding arose from the fact that the IRS aggregates all of your traditional IRAs when calculating the taxable percentage of a conversion. That is, if you have multiple traditional IRAs, they’re all considered to be one big traditional IRA for the purpose of this calculation.*

The percentage of the conversion that is not taxable is calculated as:

  • The sum of all non-deductible contributions in all of your traditional IRA, divided by
  • The sum of: all of your traditional IRA balances on 12/31 of the year of the conversion, plus any distributions you made during the year, plus any conversions made during the year.

The idea behind this calculation is to make it so that you won’t have to pay tax twice on a given amount of money. That is, if you didn’t get a deduction when you put money into the traditional IRA (i.e., you paid tax on the money before it went into the account), then you should not have to pay tax again when you move the money to a Roth IRA.

For example, if you have one traditional IRA, and it has a value of $10,000, of which $3,000 came from non-deductible contributions, and you convert the entire traditional IRA, only $7,000 of the conversion would be taxable. The $3,000 nondeductible contribution gets to be converted tax-free.

But in the event of a partial conversion, you don’t get to choose which dollars get converted. Instead, your conversion is considered to come from non-deductible contributions and from pre-tax money on a pro-rata basis — hence the need for the math above.

*This is not true for all IRA-related applications. In some cases, the IRS does consider separate accounts to be separate accounts.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions, exemptions, and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

Investing Blog Roundup: ETFs vs. Index Funds — Why Not Both?

I’m frequently asked what I think about using ETFs as opposed to index funds. As I’ve written before, I don’t think it makes a big difference for most investors. And, as Rick Ferri reminds us this week, there’s no reason you can’t use  both.

Other Money-Related Articles

Thanks for reading!

HSAs and Medicare: a Potential Social Security Pitfall

A reader writes in, saying:

“I thought that I completely understood [Social Security strategies] but I sure didn’t understand the Medicare Part A/HSA complication.  Please make sure that your readers are aware of this significant complication, which doesn’t exist if you don’t have an HSA.”

The complication the reader is referring to is that, beginning with the first month you are enrolled in Medicare, you cannot contribute to a health savings account (HSA). The potential trouble arises as a result of the fact that it’s possible to become enrolled in Medicare without having intended to enroll. In fact, in some cases, you may even be unintentionally retroactively enrolled in Medicare, thereby making you ineligible for HSA contributions in a month in which you already made such contributions.

Automatic Enrollment in Medicare

The following comes from the Code of Federal Regulations:

Individuals who need not file an application for hospital insurance. An individual who meets any of the following conditions need not file an application for hospital insurance:

  1. Is under age 65 and has been entitled, for more than 24 months, to monthly social security or railroad retirement benefits based on disability.
  2. At the time of attainment of age 65, is entitled to monthly social security or railroad retirement benefits.
  3. Establishes entitlement to monthly social security or railroad retirement benefits at any time after attaining age 65.

In other words, you will automatically be enrolled in Medicare Part A* when you reach age 65 if at that time you are already receiving Social Security retirement benefits (or spousal or widow/widower benefits) or have been receiving Social Security disability benefits for more than 24 months. Alternatively, if you claim Social Security benefits (including as a part of a “file and suspend” strategy) at any point after age 65, you’ll automatically be enrolled in Medicare Part A at that time.

In addition, the same CFR section states that, “an application under § 406.10 that is validly filed within 6 months after the first month of eligibility is retroactive to that first month. If filed more than 6 months after that first month, it is retroactive to the 6th month before the month of filing.” In other words, if you become enrolled in Medicare Part A after reaching age 65, they’re going to backdate your enrollment by 6 months (but no earlier than age 65).

How About an Example?

Example: Jane files for her Social Security retirement benefit at age 66. As a result of that application, she is automatically enrolled in Medicare Part A. In fact, she will automatically be retroactively enrolled in Medicare Part A going back to age 65½ (i.e., 6 months prior to her application). If Jane had made contributions to an HSA in any of those 6 months for which she is now retroactively enrolled in Medicare, she has a problem.

What To Do About This?

The way to avoid this situation is as follows:

  • If you file for Social Security benefits at any point prior to age 65, you will want to stop making HSA contributions at age 65.
  • If you aren’t claiming any Social Security benefits until after age 65, you will want to stop making HSA contributions 6 months prior to the date at which you file for Social Security benefits.

If you have already made HSA contributions in a month in which you were ineligible due to automatic Medicare enrollment, your options are to:

*When you are enrolled in Medicare Part A, you are automatically enrolled in Part B as well, but you are given the opportunity to opt out of it, should you want to do so.

Want to Learn More about Social Security? Pick Up a Copy of My Book:

Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less
Topics Covered in the Book:
  • How retirement benefits, spousal benefits, and widow(er) benefits are calculated,
  • How to decide the best age to claim your benefit,
  • How Social Security benefits are taxed and how that affects tax planning,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"An excellent review of various facts and decision-making components associated with the Social Security benefits. The book provides a lot of very useful information within small space."

Investing Blog Roundup: Why Did My Share Price Fall?

One of the most common questions I see (both via email and on the Bogleheads forum) is why the share price of a given fund went down unexpectedly — perhaps even on a day when the market is up. This week, Vanguard provides a clear answer to that question:

Investing Articles

Other Money-Related Articles

Thanks for reading!

9 Good Reasons for Claiming Social Security Early

There’s been quite a bit of talk over the last few years about the fact that most people should wait to claim Social Security, if they can afford to do so. And that’s true, for two reasons:

  1. Waiting to claim Social Security reduces risk, because it is a decision that works out best in the most financially scary scenarios (in which you live a very long time and therefore have to fund a very long retirement).
  2. Waiting to claim Social Security maximizes spendable dollars, in most cases. (That is, with inflation-adjusted interest rates as low as they are right now, for more than half of people, delaying Social Security will result in having a greater number of inflation-adjusted dollars to spend over the course of their lifetimes.)

But it’s important to understand that, while it makes sense in the majority (i.e., greater than 50%) of cases to delay, there are still many situations in which a person would be well served by claiming Social Security earlier rather than later.

The first and most obvious reason to claim Social Security early is simply that you need the income immediately.

But, beyond that, there are still several cases in which, if you do not need the risk reduction that comes from delaying Social Security, your spendable dollars are likely to be maximized by claiming benefits earlier rather than later.

What follows are eight examples of such cases. (To be clear, this is not meant to be an exhaustive list. These are simply some of the more common such situations.)

1. You are single (and have never been married) and you have a significantly shorter than average life expectancy due to a medical condition.

2. You are the spouse with the lower primary insurance amount in a married couple and you or your spouse have a shorter than average life expectancy.

3. You are the low-PIA spouse in a married couple, and you’re many years younger than your spouse (meaning that, when you are age 62, your first-to-die life expectancy is significantly shorter than the first-to-die life expectancy of a couple in which both spouses are age 62).

4. You are the low-PIA spouse in a married couple, you are younger than your spouse, and you are filing early in order to allow your spouse (i.e., the higher-PIA spouse) to claim spousal benefits while he/she allows his/her own retirement benefit to continue growing until 70.

5. You are a widow/widower, and you’re claiming retirement benefits as early as possible while allowing your widow/widower benefit to continue growing until your full retirement age. Or, you’re claiming widow/widower benefits as early as possible while allowing your retirement benefit to continue growing until age 70.

6. You have one or more children who would qualify for child’s benefits once you file for your retirement benefit (thereby making the cost of waiting significantly greater than it is for most people).

7. Inflation-adjusted interest rates are high (unlike they are right now), making the option of taking the money and investing it a better deal. (Interest rates would have to be super high, however, for this to be a good deal for the high-PIA spouse in a married couple.)

8. You will qualify for a sizable government pension from work that was not covered by Social Security, and you’re claiming Social Security spousal benefits early while delaying your pension (so that the pension grows and so that you can put off applicability of the government pension offset).

Want to Learn More about Social Security? Pick Up a Copy of My Book:

Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less
Topics Covered in the Book:
  • How retirement benefits, spousal benefits, and widow(er) benefits are calculated,
  • How to decide the best age to claim your benefit,
  • How Social Security benefits are taxed and how that affects tax planning,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"An excellent review of various facts and decision-making components associated with the Social Security benefits. The book provides a lot of very useful information within small space."

Investing Blog Roundup: Do You Have a Portfolio or Investment Collection?

This week, Jim Dahle addresses an exceedingly common investment mistake: having a portfolio that’s really just a collection of investments that you’ve accumulated over the years — as opposed to an actual portfolio with a coherent strategy.

Investing Articles

Other Money-Related Articles

Thanks for reading!

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