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5 Common Roth Conversion Mistakes

Converting your Traditional IRA to a Roth IRA can be a useful strategy for many investors. However, mistakes along the way can cost you—we’ll help you avoid them.

Articles by Chrissy Celaya, CFP®
By Chrissy Celaya, CFP® Customer Insights Supervisor, Betterment Published Feb. 15, 2019
Published Feb. 15, 2019
4 min read

Taxes are treated differently between Traditional and Roth IRAs. Traditional funds are taxed at retirement, whereas Roth funds are taxed when you put them into your IRA. Transferring funds from a Traditional IRA to a Roth IRA is called a Roth conversion. With a conversion, you are essentially changing money that hasn’t been taxed yet into money that has been taxed—and paying the resulting taxes due from the conversion.

There can be many reasons for why you may want to go ahead and pay taxes in the present rather than in the future.

In this article, we’ll focus on several mistakes that can occur when performing a Roth conversion. These mistakes are common enough that anybody contemplating a Roth conversion should be aware of them. Since Betterment is not a tax advisor, please consult a tax advisor if you have questions on how a Roth Conversion would affect your specific tax situation.

See step-by-step instructions for converting your Traditional IRA to a Roth IRA.

1. Convert Too Late

Most of us don’t think about taxes until April, when we have to actually file. However, by waiting this long to convert from a Traditional IRA to a Roth IRA, you may be paying more taxes than you need to.

Remember that you only pay taxes on the amount you convert.

Let’s say you convert $10,000 in January and it grows to $11,000 by the time you file your taxes in April. You still only pay taxes on the $10,000. Had you waited until tax time, you would have had to pay taxes on $11,000 instead.

As with many things, it pays to plan ahead. If you plan on doing a conversion, do it as early in the year as possible—preferably in January, in order to give your money the longest amount of time in the market as possible so that it can grow tax-free.

2. Convert Too Much

Roth conversions can be a powerful strategy, but blindly converting can end up causing more harm than good.

A common strategy used to avoid paying more in taxes than you may have to is called “bracket filling.” You determine how much room you have until you hit the next tax bracket, and then convert just enough to “fill up” your current bracket.

For example, if you are married filing jointly and have taxable income of $100,000, then you have about $71,050 of room before jumping from the 22% Federal tax bracket to the 24% bracket. It’s worth noting that certain state tax rates can be impacted as well and the rules vary state to state.

Converting any more than what you have left to fill up your current tax bracket would likely cause you unnecessary taxes. You can work with your tax preparer to find exactly how much room you have and how much to convert.

3. Convert Too Little

On the other end of the spectrum, many people are too conservative when calculating how much to convert and end up missing out on valuable room in their tax brackets.

To be clear, going into the next bracket is probably not what you want to do. However, nobody knows exactly what bonus they’ll get, or how many dividends they will receive, so guessing the exact dollar amount is impossible. Since we no longer have the luxury of undoing a Roth conversion, it’s more important than ever to take extra care when running the numbers.

If most or all of the Traditional IRA is comprised of after-tax contributions, delaying or avoiding a conversion may only increase the taxable earnings later. See Smart ways to minimize taxes on a conversion.

4. Keep the Same Investments

Conversions can be a great tool, but don’t stop there. Once you convert, you should also adjust your portfolio to take advantage of the different tax treatment of Traditional and Roth accounts.

Each account type is taxed differently and many investments grow differently, too. You can take advantage of this by strategically coordinating which investments you hold in which accounts. This strategy is called asset location and can be quite complex. Luckily, we automated this strategy through our Tax-Coordinated Portfolio feature, which can boost your returns by an estimated 0.48% per year.

Pairing asset location with Roth conversions can help supercharge your retirement plan even further.

5. Pay Taxes From Your IRA

Paying any taxes due from the conversion out of the IRA itself will make any Roth conversions you do less effective.

If you convert $10,000 and are in the 22% tax bracket, you will owe $2,200 in taxes. One option is to pay the taxes out of the IRA itself. However, this will mean you paid taxes on $10,000 but only have $7,800 left to grow and compound over time. If you are under the age of 59 ½, the withheld amount will also be subject to a 10% early withdrawal penalty.

Instead, consider paying taxes owed using excess cash or a non-retirement account you have. This will help keep the most money possible inside the Roth IRA to grow tax-free over time.

Step-By-Step Instructions

We recognize that many investors are interested in this technique, so we’ve created a quick process that allows an investor to authorize a Roth conversion online in less than a minute.

  1. Log in to your account on a web browser.
  2. Click on Settings in the menu on the left-hand side of the page.
  3. Click the Accounts tab at the top of the page.
  4. Find your Traditional IRA and click the 3 dots that appear off to the right.
  5. Choose the option that says “Convert IRA to Roth.”
  6. You’ll have the option to convert either a partial amount or the full amount.

For questions regarding whether or not converting is the best option for you, please consult a tax advisor, as Betterment is not a tax advisor and cannot provide tax advice for your specific situation.

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