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Roth conversions can be an effective strategy for creating tax-free income in retirement.
But Roth conversions can also get complex, and if you’re not careful, it’s easy to make mistakes that could end up costing you a lot of money.
From understanding the right timing to managing your tax implications to more nuanced areas such as how your Roth conversion can impact your Social Security taxes and Medicare premiums, the process can be more tricky than it appears.
Before we look at how to avoid common Roth conversion mistakes, let’s first explain how Roth conversions work.
What is a Roth Conversion?
If you’re not familiar with Roth conversions, it involves transferring funds from a traditional pre-tax retirement account, like a 401(k) plan or traditional IRA, to a Roth IRA.
The main reason to do Roth conversions is for the potential to pay less taxes in the future. When you do a Roth conversion, you pay income tax on the converted amount now, but your future withdrawals from the Roth IRA account are tax-free.
With traditional IRA or 401(k) plans, the money you’ve contributed hasn’t been taxed yet. When you convert money from these traditional retirement accounts, this amount is added to your gross income for the tax year in which you make the switch.
Let’s say you have $100,000 in your traditional IRA and you decide to do a Roth conversion on the full amount. Let’s also assume your tax bracket is 25%.
Your taxable income for the tax year will increase by $100,000. If this additional income doesn’t push you into a higher tax bracket, you’ll owe $25,000 in taxes from the conversion (25% of $100,000).
Another reason to do a Roth conversion is to avoid Required Minimum Distributions (RMDs).
RMDs are the minimum amounts that a traditional retirement plan account owner must withdraw annually starting with the year they turn 73. These RMDs are taxed as ordinary income and can potentially push you into a higher tax bracket, which means you’ll have a higher tax bill.
Traditional IRAs and 401(k) plans are subject to RMDs, but Roth IRAs aren’t.
This means that the money in a Roth IRA gets to continue to grow tax-free for as long as you live, and you aren’t forced to start withdrawing it at a certain age.
A lesser-known benefit of converting your traditional retirement money to a Roth IRA is that beneficiaries can inherit and withdraw from Roth IRAs tax-free. This makes the Roth IRA an ideal tool to effectively transfer your wealth.
Finally, well-planned Roth conversions can minimize the impact on Social Security taxes and your Medicare premiums.
Common Roth Conversion Mistakes
If you’re contemplating a Roth conversion, you’ll want to be aware of certain aspects before pulling the trigger. Let’s break down some of the most common mistakes people make when doing Roth conversions and how to avoid them.
1. Overlooking the full tax consequences
If you’ve weighed the benefits of a Roth conversion and decided it’s the right move, the next step is to decide on the amount to convert. With a Roth conversion, you’ll pay taxes on the converted amount for the year you perform the conversion.
Although it can tempting to convert a large sum in one year, doing this can push you into a higher tax bracket and a larger overall tax liability.
Instead, a more strategic approach is to consider gradual conversions over several years which can allow you to maximize the benefits of lower tax brackets.
However, converting too little each year could mean that you’ll end up having a substantial amount in your traditional retirement account, potentially leading to larger Required Minimum Distributions (RMDs) and higher taxes in retirement.
The key is to find the “sweet spot” or the optimal amount you can convert each year without moving into a higher tax bracket.
Keep in mind that Roth conversions increase your taxable income for the year, which can affect other income-based tax benefits and credits.
For example, doing a conversion might reduce your eligibility for certain deductions or even increase your Medicare premiums if you’re a retiree (more on this below).
For high-income earners such as physicians, a substantial Roth conversion could trigger the Alternative Minimum Tax (AMT), potentially negating some of the conversion’s benefits.
Lastly, some states don’t tax Roth conversions, but others do. Be sure to understand if your Roth conversion will mean creating an additional state tax liability as well.
2. Not factoring increased health insurance costs
Most people focus on the tax implications of a Roth conversion, but they forget to assess how these conversions can potentially affect their health insurance costs, both before and after Medicare.
When you do a Roth conversion, you’re essentially prepaying taxes, which increases your adjusted gross income (AGI). This can impact your Health Insurance Marketplace, also known as the ACA (Affordable Care Act) Marketplace subsidy.
As an example, take a married couple with a combined income of $50,000. Based on their income, they are eligible for a significant ACA subsidy, potentially saving thousands of dollars annually on health insurance.
If they do a Roth conversion, their AGI will increase, possibly pushing them into a higher income bracket and reducing their subsidy or even eliminating it entirely. This could mean they’ll end up paying much more in healthcare costs.
3. Not factoring increased medicare premiums
Another area where people often neglect to assess before doing Roth conversions is how it will impact their Medicare premiums.
Medicare premiums, particularly Part B (medical insurance) and Part D (prescription drug coverage) are impacted by your income. This is known as the “Income Related Monthly Adjustment Amount” (IRMAA).
IRMAA is an additional charge on top of the standard Medicare Part B and Part D premiums, determined by your MAGI from two years prior.
For example, your 2024 premiums are based on your 2022 MAGI. If a Roth conversion pushes your income above the IRMAA thresholds, you could face higher Medicare premiums.
For 2024, the standard monthly premium for Medicare Part B is $174.70. If your MAGI exceeds $103,000 for individuals or $206,000 for married couples filing jointly, you will pay more.
The premiums increase based on tiers. If your MAGI exceeds these tiers, you’ll pay an additional premium between $244.60 to $594.00.
Medicare recipients with 2022 incomes exceeding $103,000 for individuals or $206,000 for married couples filing jointly will pay an additional Part D premium between $12.90 to $81.00.
Crossing these thresholds by even a small amount can mean a substantial jump in your Medicare premiums.
One way to mitigate these increases is to time your Roth conversion during years when your income is lower. This can reduce the risk of crossing IRMAA thresholds. Another strategy is to spread your conversions over several years. Converting smaller amounts annually can help manage your taxable income more effectively and potentially avoid higher IRMAA brackets.
4. The “social security tax torpedo”
Another area where people have made costly mistakes with Roth conversions is during retirement when they receive Social Security benefits. Social Security income is taxed based on a formula and doing a Roth conversion can increase the amount of Social Security income subject to tax.
This is also known as the “Social Security Tax Torpedo” which is the unexpected increase in taxable Social Security income after a Roth conversion.
When you perform a Roth conversion, the amount converted is added to your taxable income for that year. It’s this increase in taxable income that can push your total income above certain thresholds.
If your total income exceeds these thresholds, a larger portion of your Social Security benefits becomes taxable, which can leave you with an unexpected increase in taxes, potentially negating some of the benefits of the Roth conversion.
Again, do a careful assessment of your expected income when factoring in a Roth conversion.
5. Not understanding the pro-rata rule
Another lesser-known aspect regarding Roth conversions is known as the Pro-Rata Rule.
The Pro-Rata Rule is an IRS rule that comes into play when you have both pre-tax and after-tax amounts in your traditional IRAs and want to convert only the after-tax amounts to a Roth IRA.
This rule determines how much of your Roth conversion will be tax-free, taking into account the mix of pre-tax and after-tax contributions across all your IRAs.
According to this rule, you’re not allowed to selectively convert only the after-tax amounts. Instead, each conversion is considered to come proportionally from pre-tax and after-tax amounts.
To calculate the Pro-Rata percentage, add up the total balance of all your traditional IRAs, including pre-tax and after-tax amounts. Then, calculate the percentage of the total balance that is pre-tax. This is your Pro-Rata percentage.
For example, you have a combined IRA balance of $1 million, with 5% of that amount representing after-tax contributions. This means 95% of your IRA balance is made up of pre-tax contributions.
If you decide to convert $30,000 of this balance to a Roth IRA, the pro-rata rule says that only 5% of the converted amount, or $1,500, will be considered tax-free.
The remaining $28,500 will be subject to tax in the year of the conversion. This rule is in place to prevent people from bypassing the Roth income limit and manipulating funds to lower their tax bill.
If you have a mix of pre-tax and after-tax amounts in your IRAs, you may want to consider other strategies, such as rolling over your pre-tax amounts to a 401(k) plan before performing a Roth conversion.
6. Paying taxes with IRA funds
Another mistake people make when doing Roth conversions is using funds from their IRA to pay for the tax bill. Why is this a mistake?
It’s because you’re essentially paying taxes twice on the same money. In addition, when you use IRA funds to pay the conversion tax, you’re effectively reducing the amount of money that’s working for you in your retirement account.
This means less money growing tax-free in the Roth IRA, which reduces your retirement savings in the long run.
On top of that, if you’re under 59 1/2 years old and use IRA funds to pay the conversion tax, the amount used to pay the tax is considered an early distribution. This could subject you to a 10% early withdrawal penalty, which increases the cost of the Roth conversion.
Ideally, you should pay the tax on a Roth conversion with non-IRA funds. This way you’ll preserve the full amount of your retirement savings and avoid any early withdrawal penalties.
If you don’t have enough non-IRA funds to cover the tax bill, then consider converting smaller amounts over several years to manage the tax impact.
7. Holding the wrong assets in your Roth IRA
You’ve probably heard that asset allocation is one of the most important aspects of your investment strategy. With Roth conversions, asset location is just as important with this being one of the key strategies to maximizing its tax-free growth potential.
By holding assets with higher growth potential, like growth stocks, within your Roth, you fully leverage the tax-free growth benefits of this account.
Your Roth IRA lets your investments compound without any tax drag. And when you begin withdrawing from it, you won’t pay any tax on your withdrawals, including the earnings.
However, if you hold lower-growth assets in your Roth IRA, such as bonds, money market funds, and cash, you’re likely leaving money on the table.
After completing a Roth conversion, reassess and adjust your traditional IRA and Roth portfolios. This way you make sure that you’re optimizing your portfolio for both growth and tax efficiency.
Strategic Planning
A well-executed Roth conversion can provide lots of benefits in terms of your retirement planning. You’re essentially paying taxes upfront but your money grows tax-free within the Roth IRA, can be withdrawn tax-free, and avoid RMDs.
If you’re not careful, making any of these Roth conversion mistakes could negate some of its benefits. Before you decide to convert, review and estimate your immediate tax bill and the impact of the conversion on other areas such as your healthcare costs, Medicare premiums, and Social Security taxes.
Be strategic with your Roth conversions by staggering them over multiple years which can minimize or eliminate Roth conversion mistakes.
Roth conversions can be complex, so work with a qualified financial planner or your tax advisor to develop a plan that minimizes these risks and maximizes the benefits of your Roth conversion.
2 thoughts on “How to Avoid These 6 Costly Roth Conversion Mistakes”
Thanks for the article, it’s a topic I’ve been thinking about a lot lately. Do you have any software you would recommend for modeling different scenarios?
Margo
Good article, but I struggle with #6. I agree that there is an advantage for folks that already have sufficient taxable dollars to cover the conversions, but disagree that you shouldn’t convert if you only have IRA funds.
Paying the tax for conversions with taxable dollars is also paying taxes twice. Initial taxes were just paid earlier, so they may not be as obvious. If one were to model someone preretirement, and in one scenerio they contribute 100% to qualified accounts, but in a second scenerio the funnel some of the dollars from the qualified to a taxable account in order to build up the surplus for later covering Roth conversions, there would not be a significant difference.
It’s true, not using taxable dollars will lesson your Roth balance, but so would have diverting dollars during your saving years from the pre-tax to taxable accounts. Again, it just may be less obvious.
Greatest advantage actually would be for someone that already has significant taxable dollars, using the money to convert is like a backdoor way of moving funds from a taxable accounts into Roths. The advantage then is the future growth of that money now grows tax free. This advantage however only exists if the person was going to maintain a large balance for many years in the taxable. If they are planning to exhaust or minimize their taxable funds anyway once the Roth is funded, this future benefit goes away.
Bottom line – If someone already has the funds available in taxable accounts, using them to convert is the way to go.
If one does not have taxable dollars available, they should still consider Roth conversions, as they may still help minimize future RMDs, converted funds have some tax benefits to themselves and heirs, and the taxes on those dollars were owed anyway (unlike the taxable funds in which taxes have already beed collected).
My 2 cents