Since the Roth IRA was created by the Taxpayer Relief Act of 1997, it’ been an appealing addition to retirement planning. While contributions to a Roth are not tax-deductible, the trade-off is tax-free and penalty-free withdrawals after you cross the age of 59 ½. The withdrawal benefit is one reason many people consider converting their traditional IRAs to Roth IRAs. Also, there is no Required Minimum Distribution (RMD) on a Roth IRA as there is on a traditional IRA.
As with any plan, there are conversion strategies. For example, converting during your working years when tax rates may be lower than in retirement. Or spreading conversions over time to avoid being pushed into a higher tax bracket. Roth conversions can be a useful planning tool, but they can also be complex, and not knowing the rules for your particular situation may set you up for expensive consequences you didn’t expect.
Jamie Hopkins, director of retirement research at Carson Group, says there are three particular conversion traps to be aware of.
- The 10% penalty trap
When you convert tax-deferred money in an IRA to a Roth IRA, you pay ordinary income taxes on the converted amount but not the 10% early distribution penalty tax. But, if you take money out of the IRA to pay for the conversion, you could trigger a 10% penalty on that portion of the money if the owner of the IRA is under age 59 1/2 and no other applicable exception to the penalty applies.
Planning tip: Pay taxes owed on a conversion from outside the IRA. This avoids the 10% penalty issue and allows you to convert more tax-advantaged money into the Roth IRA.
- Backdoor Roth conversions
A huge issue that comes up from time to time when doing a Roth conversion is not aggregating all IRAs together. This often happens when someone’s income exceeds the limit for Roth contributions and they try to engage in a backdoor Roth transaction.
Instead of contributing directly to a Roth IRA, they contribute a nondeductible amount to an IRA and convert it to a Roth IRA. If the nondeductible contribution is the only money in the IRA, no taxes will be due at conversion, thereby getting around the Roth IRA contribution limits. However, if other outstanding IRAs existed, including SEP and SIMPLE IRAs (which are really the accounts people forget about), the person would need to aggregate all the accounts for the purpose of a conversion.
For example, imagine you have a $495,000 SEP IRA and make a $5,000 nondeductible contribution to an IRA as a backdoor Roth conversion of $5,000. You need to aggregate all IRAs, which means your nondeductible contribution is only 1% ($5,000/$500,000) of the existing total IRA amounts. Only 1% of your conversion will be tax-free. The other $495,000 will be subject to ordinary income taxes.
Planning tip: If you want to engage in the backdoor Roth IRA strategy but have existing outstanding IRA money, consider rolling it back to a company 401(k) plan if possible. Or, just make sure you understand you’ll pay taxes on the conversion until all of your taxable portion is converted or withdrawn from the IRA.
- Can’t convert RMDs
You can’t convert or roll over a required minimum distribution. Timing still plays a role, though. You can do Roth conversions after age 70½, but you need to be careful not to convert an RMD.
In the year you reach age 70½, the first distributions you make from an account subject to RMDs are treated as RMDs. Let’s say you’re 71 years old. You want to spread out the RMDs throughout the year — the total is $24,000, so over 12 months it would be $2,000 a month.
That’s all fine and dandy. But now let’s say halfway through the year you decide it’s a good year to do a Roth conversion of $10,000. If only $12,000 of the $24,000 RMD has been taken out at that point, the $10,000 conversion will be treated as an improper rollover and contribution to a Roth IRA. To fix this would require pulling out the money and all gains, or doing a recharacterization of an excess contribution. However, this highlights the point that timing is important.
Planning tip: You can do Roth conversions after age 70½, but make sure all RMDs are taken before any Roth conversions occur. Any converted amounts will be in addition to all other RMDs, perhaps causing that year’s tax bill to rise.
Roth conversion strategies can add a lot of value to a retirement income plan, but you need to know the rules so as not to cause extra headaches or tax burdens.