Nine Roth IRA Conversion Mistakes

The following is an excerpt from The Gospel of Roth: The Good News About Roth IRA Conversions and How They Can Make You Money, a book that argues everyone should convert a Traditional IRA to a Roth IRA. This is a follow-up from two posts yesterday (here's #1 and here's #2) on the same topic.

MISTAKE 1. NOT TAKING THE ROTH CONVERSION OPTION.

To properly judge whether to commit to a Roth IRA conversion, you must make the Roth conversion(s) first and wait until near the end of the recharacterization deadline to decide. For 2010, the first day to convert is January 4, and the unconversion deadline is 651 days later on October 17, 2011. Any decision not to convert before participation in the RCO is potentially a huge mistake. You can always undo any and all Roth conversions before the deadline, but you cannot backdate the conversion. Account performance and announced future tax rates during the RCO period may make your decision easier.

MISTAKE 2. CONVERTING TO A ROTH IRA TOO QUICKLY.

If you have the benefit of time (as in several years before you are age 70 1/2) and your income tax brackets are not near the top brackets, you may benefit by converting only partial amounts of your regular IRA to a Roth each year. By converting to Roth IRAs over several years, you may better utilize the lower tax brackets and increase the Roth conversion advantage. You still will want to convert the entire regular IRA at first by using the RCO so you can pick and choose the accounts that remain Roth IRAs and preserve all of your future options.

MISTAKE 3. CONVERTING TO A ROTH IRA TOO SLOWLY.

If you are near age 70 1/2, you may want to complete your Roth conver¬sions more quickly based on your specific situation. Also, top tax bracket earners (Type 1s) who have outside non-IRA funds to pay the income tax may want to convert sooner as well. The threat of higher income tax rates in the future and avoiding mandatory regular IRA distributions should be considered. The complete RCO should be utilized as always to preserve future options.

MISTAKE 4. NOT CONVERTING INTO SEVERAL NEW SEPARATE ROTH ACCOUNTS.

Roth IRA conversions may be undone or recharacterized on an account-by-account basis without affecting the status of other conversion accounts. If one of your Roth conversion investments goes way up and another goes down before the deadline to unconvert, you may undo the loser and keep the winner only if you converted the two investments into separate accounts. I suggest you convert into several new separate accounts based on asset class. Be sure to convert into new Roth IRA accounts for the RCO period. After the deadline for recharacterizations, you may consolidate all of your Roth accounts.

MISTAKE 5. NOT USING AN IRA INHERITANCE TRUST.

There are many benefits in using a trust as the beneficiary of your Roth and regular IRAs. Beneficiaries of IRAs often make mistakes with inherited IRAs by removing the money more quickly than the IRS required distributions instead of extending the tax benefits as allowed. By using a specifically designed IRA Inheritance Trust, you can provide maximum protection and flexibility as well. You can financially protect the heirs from divorces, creditor claims, and sometimes even the heirs themselves.

MISTAKE 6. NOT REALLOCATINGINVESTMENT ASSETS AFTER RCO.

After the deadline to unconvert or recharacterize has passed, you should reallocate and rebalance the Roth IRA assets. This is especially true if some accounts were unconverted back to regular IRAs; you definitely want to protect the Roth IRAs from sharp declines if possible by using asset allocation. If you enjoyed a large gain during the RCO period with an investment that has great volatility, care should be taken to not give back the gain in the Roth, if you can shift the more volatile investments to the regular IRAs for the next RCO period. You also will want to al¬locate all of your assets (IRA and non-IRA), for maximum income tax efficiency because some assets are better suited for non-IRA accounts.

MISTAKE 7. IGNORING STATE INCOME TAX.

State income tax is a factor that must be considered with the Roth IRA conversion. Generally, the consideration of state income tax makes the appeal of Roth IRA conversions even greater. Even if you live in a state with no income tax, consider where you may live in the future as well the state(s) were your heirs reside. Also, many states may sharply increase their income tax rates in the future.

MISTAKE 8. NOT BECOMING A TYPE 1.

Before you have completed the RCO period, make sure that you are not at least a partial Type 1. Type 1s are folks who have the money to pay the income tax when converting to a Roth from non-IRA funds. Consider every other possibility and resource before you unconvert or pay the tax from the IRA. Remember, if you are over age 59 1/2, you may remove immediately any amount from the converted Roth with no penalty or additional income tax, up to the total converted. So the Roth IRA conversion funds could be considered your emergency account if you are over age 59 ½.

MISTAKE 9. TAKING ADVICE FROM THE WRONG PEOPLE.

Many newspapers and magazines have had articles about Roth IRA conversions. Many have led people to the wrong conclusions or at least been confusing. Most insurance and investment companies have Roth IRA conversion calculators and literature. Most financial advisors have opin ions as well. Warren Buffett said, “Wall Street is the only place that people ride to in a Rolls Royce to get advice from those who take the subway. Make sure that you do the Roth Conversion Option and analyze your situation before the deadline to unconvert very carefully. Expert advice on this process may be very helpful, but be sure your advice is coming from a true expert in this subject.

Comments

[Melissa]

Just to be sure I understand - the benefit of a recharacterization is if your investment falls in value, you can recharacterize and then after waiting the prescribed time, reconvert at a lower value (and hence a lower tax)?

Obviously, the recharacerization doesn't undo the loss of money :)

[Ryan@Fincycle]

I'm just not convinced that converting my traditional IRA to a Roth makes sense. I think the only people that should do this are people that can't otherwise contribute to a Roth because the make too much. Think of it like this, right now most FMF readers are probably in a tax bracket higher than 15%. To fill up that lowest bracket after you retire (assuming you are using your trad IRA funds at 4% withdrawal) you would need a balance of $2.2M in today's dollars. Also, what happens if the tax hikes are of the VAT or sales tax variety? Or if Roth rules are changed? Don't think that the US government is below taxing money twice (Corporations and dividends come to mind). I definitely max my Roth contributions each year, but my IRA is staying where it is.

[Bob]

When IRAs came out many years ago the idea was to POSTPONE paying taxes to Uncle Sam as long as possible. The idea being that it was better to keep you money working for you now, and pay Uncle Sam later with dollars that are worth LESS(due to inflation).

I'm sure there are instances where it makes sense to convert an IRA to a Roth.

I'm not converting any of my IRAs. I think we have lots of inflation headed our way in the years to come. I agree with Ryan's post in that the tax code could and probably will change in the future. There's a ton of money in IRAs around the country. The government is salivating at the opportunity to get their hands on it. Converting to a Roth plays right into the government's hand!

I am 50 years old. I'm holding on to my money as long as possible. Never pay a tax today that you can pay with cheaper dollars tomorrow.

[Manjinz]

When do you do the Roth conversion, make sure you have enough funds to pay the taxes upfront. For example, a taxpayer in the 28 percent federal tax bracket who shifts $100,000 of pretax dollars to a Roth IRA from a traditional IRA would pay $28,000 in taxes, in addition to whatever is owed in state taxes. “There are many people who simply don’t have that kind of a side account to pay the income tax, so for them it isn’t very practical to consider a Roth,” said Christine Fahlund, a senior financial planner at T. Rowe Price Group Inc. in Baltimore.
Source: http://www.definerothira.com

A partial conversion to a Roth IRA from a traditional IRA may be the most tax-efficient plan because of the diversification benefits, said Orecchio, who estimates about half of his clients may convert some money to a Roth IRA next year. “You never know how the tax code will work in the future. By owning different IRAs, you’re protected from whatever the government might decide to do,” Orecchio said.