Note: On November 9, 2017, I modified this post to correct an error that caused my 2017 Colorado state taxes to be under reported by $114. Thanks to reader Mark from Minnesota for emailing me about this mistake!
As I plan my household’s tax returns for 2017, I’m pursuing four major goals: (1) obtain the highest available Premium Tax Credit under Obamacare; (2) avoid Medicaid eligibility; (3) maximize the amount of my Roth conversion; and (4) limit my exposure to federal and state income taxes.
This post shares my basic approach and seeks your suggestions for improvements.
To simplify things, let’s break the process down into several discrete steps.
Step 1: Figure the Highest Income that Yields a 100% Premium Credit
One of the biggest challenges of early retirement is paying for health insurance. Since 2013, individual health insurance premiums have risen 99 percent and family premiums have risen 140 percent. See eHealth.com.
Fortunately, Obamacare offers a cure for skyrocketing insurance costs: the Premium Tax Credit (PTC).
To receive a PTC our household must split the uprights between making too little and too much income. If we make too little, we drop out of Obamacare and into Medicaid. This rules out any PTC and subjects us to coverage that we believe is inferior to private health insurance. The PTC also disappears if we make too much. This happens when household income exceeds 400% of the applicable poverty line (the government draws this line based upon the insured’s state of residence and household size).
For PTC purposes income is calculated as Modified Adjusted Gross Income (MAGI). For most taxpayers, including us, there exists no difference between MAGI and the Adjusted Gross Income (AGI) reported on line 37 of Form 1040. This is true because most households don’t experience any of the three narrow circumstances that trigger MAGI modifications: (1) non-taxable social security benefits (Form 1040, lines 20(a)-20(b)); (2) tax-exempt interest (Form 1040, line 8b); and (3) excluded foreign earned income and housing expenses for those who live abroad (Form 2555, lines 45 and 50).
To figure the highest MAGI we can earn that will still provide a 100 percent PTC, I make use of this website’s 2017 Obamacare PTC Calculator.
On line 5 of the calculator, I enter progressively higher amounts for my MAGI number until line 12 shows that my monthly cost of premiums is just above zero. Then I reverse course. I keep reducing my MAGI number by just a few dollars at a time until line 11 of the calculator reports that my monthly premium tax credit is just slightly higher than my monthly premium reported on line 3. (It may take several attempts before the numbers finally come out right).
Here’s the PTC Calculator’s final readout as I complete Step 1 of my tax planning:
Based on these readings, I know that line 5 reflects the highest MAGI I can report on my tax return and still enjoy a 100% PTC under Obamacare. For 2017, this “MAGIcal” figure is $32,400.
Step 2: Figure the Minimum MAGI that Avoids Medicaid Eligibility
Like many others, we believe we can receive better health care from a private insurance company than from Medicaid. Accordingly, I plan our annual taxes so that we can show enough income to avoid qualifying for Medicaid—an unfortunate event that likely would bar us from receiving any PTC under Obamacare.
Medicaid eligibility is based upon a household’s Federal Poverty Line Percentage (FPLP) (see line 8 of the screenshot above).
In many cases, whether a household is subject to Medicaid presents a complex question because different states apply different FPLPs. Moreover, in most states the threshold FPLP increases if there are any existing pregnancies or children in the household. In Colorado, however, the Medicaid eligibility threshold for a household consisting of two adults is clear-cut: we qualify for Medicaid only if our MAGI falls below 138 percent of our household’s poverty line.
As the PTC Calculator reported in Step 1 above, for 2017 our household’s poverty line is $16,020 (see line 6 of the screenshot above). In order to avoid Medicaid, therefore, our household’s reported MAGI must exceed $22,108 ($16,020 x 1.38 = $22,108).
Step 3: Figure the Highest Roth Conversion Free of Federal Taxes
Subject to various rules, the IRS permits taxpayers to transfer money from traditional IRAs into Roth IRAs. This process is known as a “Roth conversion.” For details, see IRS Publication 590-A.
Why might an early retiree perform a Roth conversion?
The biggest reason is taxes. First, although taxpayers pay federal income taxes upfront on any amounts converted to a Roth IRA, they don’t pay any taxes on the Roth’s future gains if they meet certain requirements when the funds are withdrawn, i.e., the converted money has stayed in the Roth account for at least five years and they’re at least 59½ years old (or disabled or dead). Second, traditional IRAs require account holders to make required minimum distributions each year beginning at age 70½. These RMDs can push retirees into higher tax brackets. In contrast, Roth IRAs require no RMDs during the life of the original owner. If you believe your future taxes will increase either because of RMDs or the government’s insatiable need for more revenue, Roth conversions can look very attractive.
During the past few years, we’ve been very successful at converting sums from traditional IRAs to Roth accounts while paying little or no taxes. The chart below reports our recent conversions:
|Tax Year||Tax Rate||Roth Conversions||Fed Taxes||State Taxes||Total Taxes|
Making these tax efficient Roth conversions requires upfront planning. In the waning weeks of each year, I run a complete mock-up of my Form 1040, including all our anticipated interest income, ordinary dividends, qualified dividends, HSA contributions, deductions, exemptions, etc.—the whole works. I use an Excel spreadsheet for this.*
Once I’ve made all my Form 1040 entries, I start entering progressively higher values for our Roth conversions as reported on the spreadsheet’s equivalent of Form 1040 line 15b. In many years my goal is to pay zero federal tax, so when that tax line turns positive for the first time, I lower my projected Roth conversion by just a few dollars to get our federal taxable income (Form 1040, line 43) just barely back to a negative number. That’s when I know I’ve maximized the amount we can convert to Roth accounts without incurring any tax liability.
Here’s a screenshot of my mock 2017 Excel tax return for zero federal tax liability:
As this spreadsheet reports, for 2017 the most I can convert over to Roth and still avoid all federal taxes is $23,645 (Form 1040, line 15b). If I make this conversion, our resulting MAGI will be $23,259 (Form 1040, line 37). We will pay nominal state taxes of $114.
Step 4: Recheck for Medicaid Eligibility and 100% PTC
Answer: Medicaid avoided and 100% PTC preserved
I look at the MAGI amount of $23,259 that was produced in line 15b of my mock-up tax return in Step 3.
First, I check to see whether this amount is higher than the $22,108 MAGI threshold for Medicaid eligibility calculated in Step 2. It is, so I don’t have to worry that we’ll fall out of Obamacare and into Medicaid if we make a tax-free Roth conversion for $23,645. That’s good news!
Second, I see that Step 3’s MAGI figure of $23,259 is also well below Step 1’s MAGI figure of $32,400. This means that if we make a tax-free Roth conversion of $23,645, our household will still get to enjoy a 100% PTC. That’s more good news!
Step 5: Am I Willing to Convert More to Roth if it Triggers Taxes?
Answer: For 2017, the answer is yes
I’m usually adverse to paying taxes, so during many years my planning goes no further than Step 4.
For 2017, however, I’d like to convert more than a mere $23,645 to my Roth account. Upping the conversion amount will trigger taxes. But I know from preparing prior returns that these taxes will be relatively small—after all, our combined federal/state rate usually runs a modest 14.63 percent. As discussed above, I’m willing to pay such smallish taxes now because I believe that our bracket will likely be higher when I turn 70½ years old and the IRS forces me to start taking RMDs from my traditional IRAs.
How much can I increase our Roth conversion and still: (1) stay within our low combined federal/state tax bracket of 14.63%; and (2) enjoy a 100% PTC under Obamacare? I resolve these questions in Step 6.
Step 6: Figure the Highest Taxable Conversion with a 100% PTC
I return to the mock 2017 tax return spreadsheet that I used in Step 3. I keep increasing the amount of my Roth conversion in Form 1040 line 15b until line 37 is about $600 or so below my highest available MAGI number from Step 1 ($32,400). Keeping a safe distance below the Step 1 figure gives me some wiggle room in the event we receive unexpected income before the close of 2017 (this has happened before). When I finish this step, I see that a $32,500 Roth conversion will produce a MAGI of $31,724 (Form 1040, line 37), an amount which is still low enough to qualify us for a 100% PTC.
Here’s a screenshot:
Our resulting tax liability is refreshingly small and falls well within our 14.63 percent combined federal/state bracket.
For 2017, we’ll report taxable income of $8,463 (Form 1040, line 43). This triggers total taxes of $1,352 ($8,463 x 0.1463 = $1,352). On balance, I think these taxes are a fair price to pay for the privilege of converting $32,500 from traditional IRAs over to a Roth IRA.
So here’s the bottom line results of our tax planning for 2017:
- We’ll receive a 100 percent Obamacare PTC of approximately $10,408 ($867.34 monthly premium x 12 = $10,408). In other words, we both get free health insurance for the year—quite literally, a gift of the MAGI.
- We’ll be able to convert $32,500 from traditional IRAs to a Roth account. This $32,500 will grow free of taxes and won’t be subject to any further taxation when the money is eventually withdrawn. It won’t be subject to any required minimum distributions, either.
- Our total tax liability for 2017 will be $1,352, which consists of: (1) federal taxes of $846; and (2) Colorado taxes of $506.
* * *
Here are a few wrinkles to keep in mind if you’re interested in adopting this basic approach.
First, if you’ve ever contributed post-tax dollars to any traditional IRAs, that will slightly boost the tax-free amount you can convert to a Roth account. This wrinkle gets ironed out on Form 8606 and Form 1040, lines 15a & 15b. For details, read the IRS Instructions for Form 8606.
Second, it’s possible to mistakenly convert too many dollars to Roth and thereby incur unanticipated taxes, especially if you forget to tally all your income (this has happened to me). But this mistake is easily corrected. If you act fast enough in 2018, you can reverse the excess portion of your conversion through a process known as a “Roth recharacterization.” For details, read IRS Publication No. 590-A.
Third, as you can tell, it’s difficult to simultaneously maximize the PTC, avoid Medicaid, and optimize a Roth conversion—all while limiting state and federal taxes. The opportunities for missteps are many. Unless you’re a CPA, please review your version of my approach with a qualified tax advisor before you file a return.
Do you have any comments, critiques, or suggestions for improvements to my 2017 tax plan? If so, please comment below.
* Instead of creating a spreadsheet, you might prefer to create a mock return file in your favorite tax software. Just remember that if you use 2016 software, various values will likely be different from those for tax year 2017, e.g., income bracket values, the standard deduction for your filing status, etc.
Photo of early retiree plunging headlong into the tax season by www.efile.com.