Getting your Trinity Audio player ready... |
Converting your traditional IRA to a Roth IRA might seem like a straightforward financial move, but in order for it to be part of an effective strategy, roth conversion details really do matter.
As more retirees consider Roth conversions to secure tax-free growth and flexible withdrawals in retirement, understanding the potential pitfalls becomes crucial. Let’s explore seven critical mistakes that could significantly impact your retirement savings and learn how to avoid them.
1. The Hidden Cost of Converting Too Much at Once
Proper Roth Conversion planning can save you tens of thousands (if not, more) if done properly. But if done improperly, it can lead to paying too much in tax or paying other “stealth” taxes. There are some things you want to make sure you avoid:
Entering a New Marginal Tax Bracket
Each situation is different, but depending on the tax bracket you’re in, you may only want to pay up to the next bracket. Here are the 2025 Marginal Tax Brackets:
As you’ll note, there are 3 sizable jumps that take place inside of the tax brackets. Be mindful that you pay tax in that specific bracket. Note that this applies to taxable income. This could include the standard deduction or your itemized deductions, depending on how you file your federal income taxes.
Unnecessary IRMAA Premiums
The Income-Related Monthly Adjustment Amount (IRMAA) is an additional premium charged to Medicare beneficiaries. Note that Marginal Adjusted Gross Income and taxable income are different.
Here are the brackets for the IRMAA thresholds:
Complicating this further, the brackets apply to income from 2 years prior. Therefore, you should be mindful of the additional premiums you may pay 2 years into the future if you cross the threshold.
Social Security Taxation
Provisional Income is another type of income to consider in retirement. We cover the taxation of Social Security in more detail in this post *Insert link.* But note that if you increase your MAGI (which a Roth Conversion would do), it could increase the percentage of how much of your Social Security is included in taxable income.
Loss of Potential Credits or Subsidies
Again, depending on your situation, you may be eligible for tax credits in retirement. Two common ones are the Premium Tax Credit and the Saver’s Credit.
You may no longer be eligible for these types of credits depending on how large a Roth Conversion you complete. Be sure to understand your taxable situation before completing this.
To be clear, a Roth Conversion may still be worth completing, but make sure to weigh the benefits and costs of completing the move.
2. Not Coordinating with Professionals
Financial Planners may see the benefit of completing a Roth Conversion. If you handle your own finances, you may also believe it is in your best interest. But before you go ahead and do so, coordinating this move with your tax professional should be a prerequisite.
Communicating the Strategy with Tax Professional & Tax Planner
We’ve done prior videos and posts explaining how a Roth Conversion can benefit an individual or couple, but make sure it’s agreed upon by the professionals you work with.
A financial planner may make this recommendation for you because of the long-term benefits you may realize, but a tax professional may also give their thoughts of why this move may or may not make sense in the current year.
It is a good idea for the planner and tax professional to have a conversation to discuss the pro’s and con’s, rather than to leave each other in the dark when making a move.
Plan to Pay the Tax
These professionals may also recommend how you should pay the tax. If you’re under 59.5 and complete this, you may not withhold the tax from your IRA, therefore, you will need to pay the tax from another source.
Depending on your situation, this may also be the recommended strategy if you’re over 59.5. Regardless, working with your professionals to discuss this should be considered to make sure the move makes sense in the short and long term.
Allocating the Accounts Properly
Using a Roth IRA in retirement can be a powerful tool to limit taxes, but the Roth works best when time is on your side. Seeing the account grow tax-free over time can create a lump sum of money that can be accessed tax-free (assuming it is a qualified distribution).
But this is where strategy becomes important. If you invest your Roth conservatively (which, depending on your circumstances, you may need to), the growth may lag behind one that is invested more aggressively, assuming favorable market conditions.
By making sure you have an investment plan that is coordinated with your tax and income plan, you can best utilize the tax benefits of a Roth IRA.
Your Required Minimum Distribution
Lastly, when you are required to begin taking your Required Minimum Distribution, if the amount is greater than you need, it could increase the benefit of Roth Conversions.
But if your RMD is sufficient for your living expenses, it may not create a need for Roth Conversions. An issue retirees who have saved well into pre-tax accounts experience is the requirement to take from their Traditional accounts, even though they do not need to. This is where the Roth Conversion Planning can make a large difference over time for the retiree(s).
If your RMD is sufficient in providing your income, you should weigh other benefits of the Roth Conversion Planning Strategy.
3. State Tax Oversight
To complicate matters, it’s not just the federal tax that may need to be paid. Depending on your state of residence, you may also have state tax due on a Roth Conversion.
Some states do not have a state income tax, while others do. Others may only tax earned income.
You may also be planning to relocate in retirement. If you’re planning to move to another state, be sure that state taxes are considered as part of your short and long term strategy when considering Roth Conversions.
4. Undervaluing (or Overvaluing) Long-Term Benefits
Most Roth Conversions are completed with the idea that it makes sense for your long term financial plan.
It’s clear that if executed properly and your situation dictates this, it can lead to a large savings if you’re in a low tax bracket at the time of the conversion, and expect to be in a higher tax bracket when Traditional IRA distributions take place.
But the strategy may or may not make sense when considering how well your portfolio does.
If you have time on your side and are expecting a more favorable return, Roth Conversions are generally better served for you. Let’s look at an example:
- Traditional IRA Balance: $100,000
- Tax rate at Conversion: 22%
- Future Tax Rate on withdrawal: 22%
- Taxes are paid from another source
- Time Horizon: 10 Years
- 2 Market Scenarios: 7% average annual return vs 3% average annual return
At a 7% return, a $100,000 balance would grow to $196,715.
At a 3% return, a $100,000 balance would grow to $134,392.
Considering the difference, you can see the benefit of having an account that is allocated accordingly holding tax-free dollars.
As a reminder, higher returns generally carry with it higher risk. You should make sure your strategy can allow for the increased risk.
5. Poor Timing
Using our previous example, we can find that market performance can dictate the effectiveness of a Roth Conversion. One way to help take advantage of this is to consider a Roth Conversion during a down market. We walk through a scenario of this in this video here.
But while we cannot control market returns and timing, your retirement income may be something you can control.
In retirement, you may have different sources of income, including part-time work, Social Security, Pension income, and distributions from your retirement or investment accounts.
This control can allow you to lower both your Modified Adjustable Gross Income and taxable income. By taking from these accounts strategically, you can cover your expenses while also keeping taxable income low.
If Roth Conversion planning appears to be something you can consider, this planning may allow you to convert at lower marginal rates than if you were working.
Lastly, you want to consider something else outside of your control, which brings us to our sixth mistake.
6. Ignoring Future Tax Law Changes
The marginal tax brackets are passed by Congress and signed into law by the President. But these brackets are subject to change.
A brief history lesson will show us that marginal rates were lowered for an 8 year period from 2017-2025. However, pending action by Congress and the President, these rates will default back to the previous brackets.
These brackets have been adjusted for inflation, so it’s worth noting that the differences are stark. But since tax policy is dictated by the powers that be in Washington DC, a Roth Conversion strategy will also depend on future rates.
Simply put, higher marginal rates with less access to deductions would make Roth Conversions more attractive, specifically if you have an Required Minimum Distribution that is greater than you would need.
7. Estate Planning Oversights
There is also a direct benefit of leaving Roth assets to heirs and beneficiaries compared to Traditional assets.
While state laws will vary, federal laws treat Inherited Traditional and Roth IRAs similarly, but with a key difference.
Both have a 10 Year requirement to be liquidated, but distributions from a Inherited Roth IRA would not count toward income (assuming they are qualified withdrawals). Inherited Traditional IRA distributions would count as taxable income.
Therefore, your beneficiary designation is important.
If your plan is to leave assets to your children, and your children are expected to be in a higher tax bracket than you at your passing, it may benefit them to receive these as Roth assets.
However, if you plan to leave assets to children who are (and are likely to continue to be) in a lower tax bracket than you, the need to convert is less important. This would also apply to a charity as a beneficiary, since charities can receive these assets tax-free.
Make sure your strategy is aligned for your estate planning needs before proceeding.
Additional Considerations
Roth Conversion Planning takes discipline and strategy to be properly executed. In the absence of certain factors, the strategy may not make sense. But if you believe this strategy could make sense for you, it may be worth considering. Make sure you’re aware of the rules before you do this, including the Roth 5 year Rules, and if you’d like the help of a professional team, see if we could be the right fit for you.