When the IRS removed the income limit for converting to a Roth IRA, it opened the floodgates for everyone to take advantage of the benefits of converting their pretax retirement accounts to a Roth IRA. Unfortunately, it also opened the door for people who don't benefit from the conversion to foolishly pay more than they need to in taxes and penalties to make the conversion.
Miscalculating the Tax Burden
Depending on the amount you convert, your Roth IRA conversion could push you into a higher income tax bracket. For example, just because you fall in the 10 percent tax bracket because you were unemployed most of the year, doesn't mean you can convert the $500,000 you have in your traditional IRA at 10 percent tax rate. Your conversion amount increases your adjusted gross income, so some or all of your conversion might be taxed at higher rates. A second mistake you could make is that you might also miscalculate your tax burden if you mistakenly believe you can pick and choose which parts of your traditional IRA you want to convert, such as just the nondeductible contributions. Unfortunately, you must pro-rate your conversion. For example, if you have $10,000 of nondeductible contributions and your traditional IRAs are worth $100,000, 10 percent of your conversion will be nontaxable whether you convert $1,000 or the entire account.
Converting the Wrong Amount
Two other mistakes people make when converting to a Roth IRA are converting too much, or not converting enough. If you have a down year when you find yourself in a lower tax bracket, you might jump at the chance to convert money from a traditional IRA or old 401(k) plan to a Roth IRA because you expect to pay a higher rate in future years. However, remember that money you convert increases your income, so if you convert too much in any given year, you might find yourself right back in the higher tax bracket you were trying to avoid. Converting too little usually applies to older people who are attempting to convert before having to take required minimum distributions. However, it can also apply to younger people who do not take full advantage of their lower tax bracket in a given year. Yes, it may mean you have to forgo a new car or other luxury purchase because of the additional tax liability, but you will increase your tax-free retirement savings.
Unprepared for the Tax Burden
If you don't plan for the additional tax liability you'll incur from your conversion, you could find yourself up a creek without a paddle come tax time. For example, if you convert $50,000 at the 25 percent tax bracket, your income taxes will go up by $12,500. If you can't pay on time, you will owe late payment penalties and interest. Another mistake is taking money out of the conversion to pay the resulting income taxes, especially if you are under 59 1/2. Taking money out of the conversion reduces the benefits of the conversion because you don't get to move the entire amount to a Roth IRA. In addition, if you're under 59 1/2, you must pay an additional 10 percent tax on the amount used for taxes because Uncle Sam still treats it as a non-qualified distribution.
Bad Distribution Decisions
To prevent people from converting to a Roth IRA to avoid the early withdrawal penalties, the IRS makes you wait five years after the date of the conversion before you can take qualified distributions from the Roth IRA. Therefore, if you take an immediate distribution -- or any distribution within five years -- you have to pay the 10 percent tax on the distribution, even if you don't owe any additional income taxes. Also, if you anticipate eventually leaving the money to charity when you die, rather than eventually taking distributions or leaving the money to an heir who would benefit from tax-free distributions, you are essentially paying taxes on money that will never be taxed. When you leave a traditional IRA to a charity, the charity doesn't pay taxes on the distributions it takes. When you leave a Roth IRA to charity, the same thing happens, except that you needlessly paid taxes to get the money into a Roth IRA. Uncle Sam appreciates your gift, but won't reciprocate with a tax benefit in the future.
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