When they learn Roths deliver tax-free income, many people practically trip over their own feet to convert money from traditional retirement accounts to Roth accounts. However, without good planning, which includes looking at current and future tax rates, this rush to convert can be a costly mistake, says a recent article, “Roth Conversion Mistakes, Who Knew?” from Financial Advisor.
There are important dynamics to take into consideration before doing conversions, including the impact on the taxable percentage of Social Security benefits. Required Minimum Distributions can lead to larger Medicare Parts B and D premiums because of the income-related monthly adjustment amount.
The advantages of conversion are attractive. If you can afford to pay the taxes upfront and heirs will inherit a Roth, they can let it grow tax-free for a decade. A conversion can be used to create a multi-generational wealth transfer extending ten years past your own demise.
There's much to consider when you start considering the positive reasons to make a conversion.
Procedural errors happen very often. Someone might miss the December 31, 2024, deadline for a 2024 Roth conversion, thinking they have until April 15, 2025, when 2024 IRA contributions are due. The deadlines are different and need to be kept straight.
This is especially true for people doing a “backdoor Roth,” making a non-deductible contribution to a traditional IRA and then converting the account to a Roth. The tax calculation on a Roth conversion considers the year-end balances of the person's traditional retirement accounts. This includes SEP-IRAs and SIMPLE IRAs—not just the account being converted.
This most commonly occurs when someone has a small IRA account from a former employer they may have forgotten about. However, the cost can be substantial.
Another error: the income tax withheld from a Roth conversion counts as a taxable distribution, and if the account owner is under age 59 ½, there’s a 10% early withdrawal penalty.
If you convert an IRA and elect not to have taxes withheld, don’t make the mistake of forgetting to file estimated tax payments. You’ll end up with a tax penalty if you forget.
The most expensive mistake possibly comes from people who know they need to make an estimated tax payment but decide the tax cost of the conversion will be larger than the cash they have on hand, so they choose to let the conversion go. However, in many cases, taxpayers over age 59 ½ are better off converting and having taxes withheld versus not doing the conversion at all.
Reference: Financial Advisor (Dec. 1, 2024) “Roth Conversion Mistakes, Who Knew?”