Converting pre-tax retirement money to a Roth IRA is a powerful strategy for creating lifetime tax-free income and reducing future Required Minimum Distributions (RMDs). But transferring funds from a Traditional IRA or 401(k) into a Roth isn’t as simple as just clicking a button and enjoying tax-free growth.
Every dollar converted counts as ordinary taxable income in the year the conversion is completed. This can trigger a number of tax traps for that tax year if you are not careful and plan accordingly. These tax traps can wipe out or at least greatly reduce the long-term benefits of the Roth conversion, careful planning is a must before embarking on a Roth conversion strategy.
Here are five tax traps to be aware of before moving forward with a Roth conversion.
Bracket creep is a real problem
The amount converted is treated as ordinary income in the year of the conversion. This can thrust you into a higher income tax bracket than you may have expected and end up costing you more in taxes for the year than originally anticipated.
One way this can happen is if the Roth conversion is done early in the year and your other income ends up being higher than originally anticipated. Bracket creep can also trigger some other tax traps.
Related: Roth IRA conversions in your 60s and beyond: what to know
Roth conversions can trigger Medicare IRMAA
Medicare IRMAA (Income-Related Monthly Adjustment Amount) is an issue for retirees and pre-retirees aged 63 or over.
IRMAA adds a surcharge to Medicare premiums on Parts B and D if your MAGI (modified adjusted gross income) exceeds certain thresholds.
IRMAA is based on a two-year lookback, so if a Roth conversion pushes your income above the threshold in a given year, this can impact your Medicare premiums two years after the Roth conversion. For someone taking Medicare at 65, income from a Roth conversion at 63 could impact their premiums.
Deciding whether a Roth conversion is a good idea in any particular tax year takes some calculations and a review of your tax situation.
The pro-rata rule can compound matters
A backdoor Roth conversion is a popular tactic for high earners whose income exceeds direct contribution limits to a Roth IRA.
A backdoor Roth conversion generally starts with an after-tax contribution to a traditional IRA account. If you have funds in a traditional IRA, or a traditional SEP-IRA or SIMPLE IRA, then do a calculation of how much of this money is pre-tax and how much was contributed either as a Roth or after-tax to a traditional retirement account.
For example, if you have $100,000 in assets in these types of accounts and $80,000 was contributed on a pre-tax basis, then 80% of the backdoor Roth conversion will be taxable.
Note that employer-sponsored retirement accounts like a 401(k), 403(b) or a 457 are exempt from this calculation.
Paying taxes out of the converted amount is costly
Doing a Roth conversion if you don’t have the money outside of the IRA account to cover the taxes can be an expensive mistake. In many cases, the custodian will have a box that you can check to have taxes withheld.
For example, if you do a $50,000 conversion and have $10,000 withheld for taxes, only $40,000 will go to your Roth account, but the entire $50,000 will be taxable. Additionally, if you are under age 59 ½, the $10,000 could be subject to a 10% early withdrawal penalty in addition to the taxes already due.
You should generally only do a Roth conversion if you have the money to cover the taxes in an account outside the IRA.
Roth conversions before satisfying your RMD
For those who are required to take RMDs (required minimum distributions) on an annual basis, it’s important to be sure that your RMD has been fully taken for that tax year prior to doing a Roth conversion.
If you attempt to do a Roth conversion prior to having satisfied your full RMD amount for the year, the IRS will treat the amount converted as an excess Roth contribution, triggering a 6% excise tax penalty each year that the excess amount remains in the Roth account.
Before doing a Roth conversion in any year, be sure that you fully understand the tax implications to ensure that this is the right strategy for that tax year. Whether a Roth conversion is desirable can vary from year to year and often will. There may be other tax traps that apply to you beyond the five discussed above.
