Source | LinkedIn | Peter Lazaroff, CFA, CFP® | Co-Chief Investment Officer at Plancorp and BrightPlan
A partial Roth conversion is one of my favorite tools to help clients manage their retirement income taxes, so I get frustrated when I see that tool used in the wrong way.
The goal of a partial Roth conversion is to reduce the value a traditional IRA before required minimum distributions begin after age 70½—thus reducing the size of those RMDs and income tax you pay on them. Because Roth IRAs are funded with after-tax dollars, you pay taxes upfront on your contributions in exchange for a source of tax-free retirement income.
When done correctly, a partial Roth conversion allows you to make smaller tax payments overtime to avoid paying a big tax bill later on. But if done wrong, you might leave some of those potential tax savings on the table—or worse. A flawed conversion might even cost you money.
Here are five of the biggest mistakes that can often derail a Roth conversion strategy:
Being unintentional about the conversion.
Too many people pursue a Roth conversion because they’ve heard it’s a good way to avoid taxes. They think any conversion will achieve that goal. The problem is—whether they’re impatient or simply unaware—they don’t do the math to figure out the best strategy for their needs.
Instead of doing small, annual conversions people often convert way too much all at once, bumping them into a higher tax bracket and causing them to pay higher taxes than they’d owe otherwise.
On the other hand, people sometimes convert too little each year, leaving themselves with bigger RMDs and higher tax bills in retirement. The sweet spot is calculating how much extra income you can make in a given year without bumping yourself into a higher tax bracket and then converting that amount.
Paying the conversion taxes with IRA funds.
This is an easy mistake to make—but it’s also easy to avoid. Let’s say you convert $20,000 from a traditional IRA to a Roth IRA and owe $4,800 in taxes. You might decide to just pay the taxes out of that same $20,000 you’re taking out of the IRA.
