Converting pre-tax funds from a traditional retirement account to an after-tax Roth IRA (i.e., a Roth conversion) makes sense in certain scenarios. However, we recommend that you consult a trusted financial advisor and possibly a tax advisor before moving any funds. These will help you avoid five common Roth conversion mistakes.
Conversion outside the estimated tax year
You must complete a Roth conversion by the end of the year (December 31) for it to count toward your income for a given tax year. Note that this is different from the IRA contribution deadline for a given tax year, which (somewhat confusingly) applies to the next calendar year. As previously mentioned, Roth conversions require careful planning by you (and ideally your tax advisor) to determine how much to convert and when to convert.
Too much conversion
Speaking of which, the question of how much to convert is important. Converting too much blindly can push you into a higher tax bracket. A common strategy used to avoid this is called “bracket embedding.” Determine your income and how much room you have to reach the next tax rate, and convert just enough to “make up” your current tax rate.
Of course, determining your exact income can be difficult. For example, you may not know if you'll get a raise or how much dividends you'll earn in your investment account. For this reason, we highly recommend working with your tax advisor to understand exactly how much room you have and how much to convert. Thanks to the Tax Cuts and Jobs Act of 2017, you no longer have the luxury of canceling your Roth conversion.
By the way, if the market is falling, you can push more convertible shares into your current bracket, since each stock is worth less at that point. To be clear, we do not recommend making a Roth conversion just because the market is down, but if you are already considering a Roth conversion, this type of market volatility may make the conversion more efficient. may be done.
Withdrawal of converted funds too early
When making a Roth conversion, you need to be aware of the five-year holding period before withdrawing the converted funds. This is different from the five-year holding period for qualified distributions.
And, as I mentioned earlier, you will typically pay tax on the converted amount at the time of conversion, and future retirement withdrawals may be tax-free and free of the 10% penalty. However, after making a Roth conversion, you must wait five tax years before withdrawing the taxable conversion amount to avoid the 10% penalty. Withdrawals of previously converted amounts are always tax-free.
Notably, this countdown clock is based on the tax year, so conversions made during the calendar year are considered to have taken place on January 1 of that year. Therefore, even if you do the conversion in December, the five-year rule clock starts earlier in the year in January. Another thing to keep in mind is that each Roth conversion has its own five-year period associated with a 10% early withdrawal penalty.
pay taxes from IRA
Paying the taxes resulting from the conversion from the IRA itself makes the conversion less effective. For example, if you convert $10,000 and are in the 22% tax rate, you would pay $2,200 in taxes. One option is to pay the taxes from the IRA itself. However, this means that only $7,800 is left with the potential to grow and compound over time. If you are under age 59 1/2, the amount withheld for taxes will also be subject to a 10% early withdrawal penalty.
Instead, consider using your extra cash or non-retirement accounts to pay off your taxes owed. This allows you to keep as much of your funds as possible within your Roth IRA and grow them tax-free over time.
continue with the same investment
Conversion is a great tool, but it shouldn't stop there. Once you convert, you should also consider adjusting your portfolio to take advantage of the different tax treatments of traditional and Roth accounts.
Each account type is taxed differently, and therefore your investments will grow differently. You can take advantage of this by strategically adjusting which investments you hold in which accounts. This strategy is called asset location and can be quite complex. Luckily, we've automated it using the tax adjustment feature.
