Converting a traditional IRA to a Roth seems simple: pay your taxes now and enjoy tax-free growth later.
But journalist and personal finance expert Jean Chatzky has a stark warning for anyone about to make the move, and it starts with where you plan to get the money to cover the tax bill.
“The deal is that when you convert assets from a traditional IRA to a Roth IRA, you have to pay taxes on the amount you convert as soon as you do so,” Chatzky wrote on HerMoney. “And the general advice is, don’t convert from outside the IRA unless you have money to pay those taxes.”
Whatever you do, keep your hands off converted funds to cover the bill. “What you don’t want to do is withdraw money from a tax-advantaged shelter and use that money to pay taxes. This could cost you more than 30% of every dollar, depending on your tax bracket (1).”
This is an easy trap to fall into, especially as larger brokers make the conversion process largely self-serving online, requiring no advisors and providing few built-in warnings about tax impact before proceeding.
According to TIAA, the amount you convert is added directly to your taxable income for that year, which could push you into a higher bracket than you expected.
As Jonathan Fishburn, director of wealth planning strategies at TIAA, puts it, “If you’re in the 22% bracket, maybe it’s okay to move up to the 24% bracket, but you might not want to move up to the 32% bracket because that’s a big jump.”
TIAA also notes that poorly timed conversions can unintentionally increase Medicare premiums and trigger higher taxation of Social Security benefits, consequences that catch many DIY converters off guard (2).
Chatzky frames the entire decision as a bet on your future tax rate: “The reason we usually choose a traditional IRA over a Roth IRA is because we think our tax rate will go down in the future. The reason we usually choose a Roth over traditional is because we think our tax rate is lower now and will go up in the future.”
His personal opinion is that taxes will generally increase in the future. For anyone else who thinks so, he advises that “it pays to have at least some assets in a Roth.”
To minimize your tax hit, TIAA recommends taking advantage of low-income years for conversion (such as time between jobs, sabbatical, or years after retirement but before required minimum distributions (RMDs) kick in).
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Backdoor Roth is a common workaround for high earners who exceed the IRS income limits for direct Roth contributions.
According to TIAA, the strategy involves donating after-tax money to a traditional IRA and then rolling it into a Roth IRA. And because there is no tax deducted on the contribution, you generally won’t owe taxes on that contribution amount when you convert it.
But there’s a problem: There’s something called the proportionate rule, which TIAA warns “often comes with a trapdoor that confuses people.”
Instead of only allowing you to convert your new after-tax dollars, the IRS taxes each conversion based on the ratio of pre-tax and after-tax money across all of your IRAs (including traditional, SEP, and SIMPLE IRAs).
For example, if you have $95,000 in existing pre-tax IRAs and you contribute a new $5,000, your total IRA pool would be $100,000 – 95% pre-tax. When you convert that $5,000, the IRS considers $4,750 taxable and $250 non-taxable, not zero.
Dorsey Wealth Management summarizes this clearly: Unless you have an existing pre-tax IRA balance, a Roth backdoor generally results in little or no additional taxes beyond any gains. If you have a pre-tax IRA balance, the IRS puts all your accounts together, which can get complicated (3).
One way around this, TIAA suggests, is that the pro-rata rule does not apply to employer-sponsored plans such as 401(k)s or 403(b)s, but only to IRA money. Some people roll pre-tax IRA balances into a 401(k) before performing a backdoor conversion to reduce or eliminate the pro rata impact.
Vanguard points out that anyone backdooring a Roth must file IRS Form 8606 to report the non-deductible contribution and conversion.
The form “tracks your after-tax basis and ensures you don’t get taxed on the money again” when you withdraw money in retirement. If you skip this, you run the risk of paying taxes twice on the same dollar (4).
Chatzky’s summary: “What I would do is look at your traditional IRA menu… and strategically convert them based on your financial situation and your ability to pay those taxes at the time on income that is not in retirement accounts.”
The long-term case for Roth accounts is compelling; Roth IRAs feature no RMDs required during your lifetime and the potential for tax-free inheritances for your heirs, as well as tax-free withdrawals in retirement (subject to applicable rules).
But getting there without an expensive surprise takes a lot more planning than most people expect. When in doubt, consider consulting a qualified tax professional before clicking convert.
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HerPara (1); TIAA (2); Dorsey Asset Management (3); Pioneer (4)
This article was first published on: moneywise.com under the title: Financial expert warns of an IRA conversion mistake that could cost you ‘more than 30% of every dollar’
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