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Roth IRA Conversion – Avoid These Mistakes – Episode 206

Roth IRA conversion

IRA Financial’s Adam Bergman discusses the Roth IRA conversion and the five pitfalls you should avoid.


In this podcast, Mr. Bergman discusses the Roth IRA conversion. It’s a hot topic at the end of the year, since many people want to convert their pre-tax IRA into a Roth. You can pay the taxes on the conversion now and receive tax-free income during retirement. However, there are a few things to keep in mind before doing a conversion. Mr. Bergman discusses these points in Episode 206 of “Adam Talks.”

Traditional vs. Roth IRA

Before we get into the conversion aspect, let’s compare the differences of the traditional IRA and the Roth IRA. Both plans have their own, unique advantages, but also share similar characteristics. Each must adhere to the same contribution limits set forth by the IRS. For 2019, you can contribute up to $6,000 if you are under age 50 and $7,000 if you are 50 or older. This amount spans all of your IRAs, whether you have one, two or five. Further, you can invest in the same types of assets. In fact, if you self-direct your IRA, you can invest in just about anything you wish. Lastly, you need earned income each year you wish to contribute.

The major difference between the two plans is when taxes are paid. A traditional plan is funded with pre-tax money. Generally, your contribution is not taxed during the year(s) you make them. The taxes are deferred until you start withdrawing during retirement. On the other hand, a Roth IRA is funded with after-tax money. While there is no tax deduction, all qualified distributions are tax-free during retirement.

Other Differences

Traditional plans are subject to required minimum distributions, or RMDs. Once you reach age 70 1/2, you must start withdrawing from the plan, whether you need the funds or not. Conversely, Roth IRAs are not subject to RMDs. You can allow your plan to remain untouched until you need the funds. If you don’t need the funds, you can pass your Roth to your beneficiary intact.

Finally, a Roth IRA can be used as an emergency fund. Any contribution you make to the plan can be withdrawn at any time and for any reason and not be subject to tax or penalties. However, if you withdraw any funds from a traditional plan before age 59 1/2, you will generally be hit with a 10% penalty and have to pay taxes on the amount taken.

Which plan is better for you? Essentially, it comes down to your age. The younger you are, the more you can take advantage of tax-free growth. Also, if you haven’t reached your peak salary, the upfront tax break may not be as beneficial. If you are older and earning the big bucks, the immediate tax break may appeal to you instead.

What is a Roth IRA Conversion?

As the name says, a conversion is when you want to move funds, or “convert” them, from a traditional plan to a Roth IRA. There are several reasons you might want to perform a Roth IRA conversion. First, you simply did not know about the Roth option. Many people are unfamiliar with the Roth IRA. They didn’t know you could pay taxes now and receive tax-free income during retirement. Next, as you get closer to retirement, you may want to move funds from the tax-deferred account into one that is tax-free. The Roth IRA must be open for at least five years and you must be at least age 59 1/2 to receive tax-free distributions.

The most common reason to convert is when your assets are having a very profitable year. If you are invested in stocks and the markets are up 10-15% or more, you may want to pay the taxes now and see tax-free growth of your funds. However, before deciding to convert, be sure to read the five pitfalls below!

The Five Pitfalls of the Roth IRA Conversion

No Do-Overs!

When President Trump passed the Tax Cuts and Jobs Act of 2017, a part of the bill affected the Roth IRA conversion. Prior to the bill, you can re-characterize, or undo a Roth conversion. If you decided to convert thinking your assets were going to skyrocket, but instead they crashed and burned, you could change your mind. You were allowed to undo the conversion as if it never happened. This safety net allowed you the freedom to speculate a little bit. However, starting in 2018, you can no longer undo your conversion. Once you convert to a Roth IRA, you are stuck with it.

Ability to Pay Taxes

A conversion makes the most sense if you have cash on hand to pay the taxes on the conversion. Any amount converted to a Roth will be subject to tax when you file your 1040. For example, you have a $50,000 annual salary and you convert $20,000 from a traditional IRA to a Roth, you will owe taxes on $70,000 worth of income. If you can’t pay the taxes due, you are probably better off waiting to convert. Alternatively, you can decide to convert a little each year. You do not need to convert your entire IRA in one shot. This will lessen the tax burden of the conversion.

Leave your IRA Alone

Continuing on the taxes theme, you should never take money from your IRA to pay taxes on the conversion. This is what we mean when we say “cash on hand.” It defeats the purpose of a conversion if you need to take money from the IRA in order to perform it. You are better off letting your funds grow in a traditional plan, at least until you have the cash to pay the taxes on the converted amount.

Age Matters

As we mentioned above, the younger you are, the more you can take advantage of tax-free growth. If you are nearing retirement, it doesn’t make the most sense to convert unless you are looking to avoid RMDs. Someone who is 30 or 40 years old has decades of tax-free growth ahead of them. If you are 60-70 years old, you don’t nearly have enough time. Again, you are better off leaving the money where it is and deal with the taxes at a later date.

Confidence in Investments

A Roth IRA conversion makes the most sense when you expect your investments to significantly increase in value. If your $100,000 investment grows to $1 million, you’re better off paying the taxes now then waiting until retirement. However, if that investment tumbles and becomes worthless, paying taxes on that $100,000 is a bad move when the asset is worth a lot less. If you’re not confident in your investment, you’re better off holding off on the conversion. Obviously, you want to pay taxes when an asset is at it’s lowest value.

Roth IRA Conversion Conclusion

As outlined above, there are many factors to consider before doing a Roth IRA conversion. These include your age, your annual earnings, your confidence in your investments and the ability to pay taxes. As always, you should consult with a financial advisor before converting. Everyone is unique and has different financial goals and only you can decide what’s best for your future.

As always, thanks for listening and if you have any questions, feel free to leave a comment here or on the YouTube video above. To speak with us directly, give us a call at 800.472.0646. Be sure to check out our SoundCloud page for all of our podcasts.


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