Top 3 Roth Conversion Mistakes and How to Create a Backdoor Roth IRA

Roth IRAs are an attractive retirement planning tool since they are structured to afford tax-free growth and withdrawals. In addition, they don’t require the account owner to take Required Minimum Distributions (RMDs).

The IRS (Internal Revenue Service) places restrictions on the availability of such attractive perks in the form of income limitations. High-income earners whose income pushes their Modified Adjusted Gross Income (MAGI) over a certain threshold are not eligible to contribute to Roth IRAs in the traditional sense.

If you are single in Year 2020, your MAGI must fall under $139,000 for you to be eligible to contribute to a Roth IRA. If you are married and filing jointly, the threshold increases to $206,000.

However, high-income earners can take advantage of a Roth’s benefits by executing what is known as the Roth Conversion.  A Roth conversion is when an individual rolls over funds from their traditional IRA or 401(k) accounts into a Roth IRA account.

Taxes will be assessed on the funds at the time of conversion but will continue to grow tax-free. There are currently no income limitations on conversions. With anything, there is a right and a wrong way to go about executing a Roth conversion. Below are the Top 3 costly mistakes made with Roth conversions and how you can avoid them.

1. Converting Too Much, Too Fast: Countless high-income investors learn about Roth conversions and immediately want to convert all their traditional IRA funds. If you convert a lump sum, you run the risk of (1) generating an unnecessary tax liability with the IRS and (2) losing the value of compounded interest from your investments. It’s important to first ask your Certified Financial Planner to illustrate a breakeven analysis on your conversion.

Unnecessary Tax Liability – Money converted into a Roth will be taxed in the year of the conversion and has the potential to push you into the next income tax bracket. In order to avoid paying unnecessary taxes, you may only want to convert as much as will fill up your current tax bracket without bumping you into the next. It’s important to consult with your tax accountant before completing any conversion.

Loss of Compound Interest – When you convert a lump sum and hand a hefty chunk of your savings over to the IRS all at once, you lose out on the compounded interest those invested funds could have been making in the meantime. Spreading out your conversions over time allows your invested funds to continue earning interest.

2. Converting at the Wrong Time: When it comes to tax preparation, timing is crucial. As mentioned above, a conversion made during working years has the potential to push an individual into a higher tax bracket. A conversion strategy at the onset of retirement, though, could be ideal.

When you leave the workforce and enter retirement, there is a high probability that you will report a reduction of income. This time period, before an individual must begin taking his/her RMDs from retirement accounts, could be the ideal time to start converting those funds to a Roth.

Save on taxes now and in the future. Once you reach age 72, your RMD from traditional accounts will be lower, alleviating future income tax liabilities. Individuals who take advantage of this brief window between retirement and mandatory RMD dates could potentially convert more funds and save on taxes in both the near and long-term.

3. Paying Taxes Directly from the IRA: Funds contributed to traditional IRAs are often contributed pre-tax, but funds being rolled over will be taxed as ordinary income upon Roth conversion. The IRS does not care where you get the money to cover the tax liability.

There are two ways to satisfy your tax obligation on the Roth conversion:

(1) Pay the taxes due out of the rolled over amount

(2) Pay taxes with excess cash or savings

For ease and convenience, many individuals tend to choose Option 1. But, paying your taxes out of your rollover amount reduces the new Roth investable amount to grow and compound over time, ultimately rendering your conversion less effective. In order to make the most of this money movement, consider paying taxes with cash from another source Option 2.

How to Create a Backdoor Roth IRA

1. Contribute to Your Traditional IRA – Each year, make your maximum annual contribution to your traditional IRA. In Year 2020 it is $6,000 for individuals under age 50, and $7,000 for those over the age of 50 based on the current catch-up contribution provision.

2. Convert the Traditional IRA amount to the Roth IRA – This process is simple and can be completed in under a few minutes if the funds are transferred to a Roth account at the same custodian (same trustee transfer). In order to simplify the process, make your conversion within a few days of your original contribution. There is no time or dollar limit on Roth conversions, but making the conversion within the same calendar year will simplify the process.

3. Prepare to pay taxes – Only after-tax dollars go into Roth IRAs. So, if you deducted your traditional IRA contributions and then decide to convert your traditional IRA to a “Backdoor” Roth strategy, you’ll need to give that tax deduction back. When it comes time to file your tax return, be prepared to pay income tax on the money you converted to a Roth IRA.

4. The Pro-Rata Rule – If you make a partial conversion, that is if you don’t rollover the entire amount of funds in your combined IRAs to your Roth and funds still remain in the traditional pre-tax account, you will be subject to the Pro-Rata rule. Some taxpayers mistakenly believe that they can avoid the income tax liability generated by rolling over only the portion of their IRA plans that were made with non-deductible contributions.

The Pro-Rata rule is how the IRS (Internal Revenue Service) accounts for the after-tax and pre-tax funds in an IRA when a partial conversion is made. The IRS requires rollovers from traditional IRAs to Roth IRAs be done Pro-Rata. When determining your tax bill on a conversion, the IRS is going to look at your combined traditional IRA accounts.

In order to avoid dealing with this rule; ensure that the balance in any pre-tax individual retirement account is zero to avoid a tax liability from reducing the benefit of your Backdoor Roth IRA strategy.

5. Complete IRS Form 8606 – In order to avoid paying taxes twice on your conversion, you’ll want to make sure the IRS Form 8606 is completed properly. It’s important to consult with your tax accountant before completing any conversion so you can ensure you aren’t being double taxed on your strategy.

6. Repeat – Once you get in the habit of making this conversion each year, you’ll be well on your way to increased asset protection, diversified retirement income choices, and an overall lighter tax burden in future years. The greatest benefit of the Backdoor Roth IRA strategy is for high-income earners whom would otherwise be ineligible for Roth savings based on annual income limitations.

At Aventine Financial Group LLC, we recognize that a Roth conversion strategy can be a great savings and investment tool, but only when accomplished alongside suitable tax preparation and in alignment with financial planning.

If you are interested in learning more about a Roth conversion strategy or would simply like to discover more about comprehensive Financial Planning services, one of our Certified Financial Planners is here to help. Contact Us today to schedule a complimentary consultation call. We look forward to helping you Plan, Protect, and Grow your net worth!

Always, Frank

Frank J. Fiumecaldo, CFP

Founder & President


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