Converting to a Roth IRA? here are 6 tips for you

Here are some tips for anyone who is thinking about swithcing from a traditional IRA to a Roth IRA

1. Neglecting to do the conversion

“Conversions are not for everyone, but the number one mistake to avoid is to not do a conversion at all,” said Beverly DeVeny, an IRA technical consultant with Ed Slott and Company, LLC. “Why would you not want to pay taxes today at known — probably very low rates — to get tax-free income at a later date (probably at higher and maybe much higher rates)? You don’t have to convert the entire IRA all at once, but you should convert at least some of it.”

Others agree. The question is not whether but when and how, said Bruce Steiner, an attorney with Kleinberg, Kaplan, Wolff & Cohen. “For most people, the choices are 1) whether to convert all at once or over a number of years, and 2) whether to convert or start converting now, or later upon retirement,” Steiner said.

2. Failing to understand the tax consequences

While not doing a conversion might be a mistake, doing one without a thorough understanding of how the conversion will affect your taxes is an even bigger mistake, said Barry Picker, who recently served as the technical editor of “100+ Roth IRA Examples and Flowcharts,” by Robert Keebler.

“I’ve had people tell me that since they’re in the 15% bracket, they can convert their $1 million IRA and only pay 15%. It doesn’t work that way,” Picker said.

The additional income from the distribution of the traditional IRA would most likely bump you into a higher tax bracket.

3. Converting when your tax bracket is likely to fall

Truth be told, not all traditional IRA accounts holders should convert. Robert Keebler, a certified public accountant, partner at Baker Tilly Virchow Krause LLP, and author of “The Rebirth of Roth: A CPA’s Ultimate Guide for Client Care,” says it would be a mistake to convert if you are certain your tax bracket will fall in the next few years.

4. Having the taxes owed withheld from the transaction

here are several reasons why you should not have taxes withheld when requesting a conversion, said Denise Appleby, founder of and chief executive of Appleby Retirement Consulting. These include:

The amount withheld reduces the conversion amount. For instance if you request a conversion of $100,000 and ask to have 20% withheld for federal taxes, then $20,000 is paid to the IRS as an advance payment of income tax for the year. Technically, this amount is a distribution and not a conversion, and $80,000 is converted to your Roth IRA.

You may need to reverse the conversion for several reasons, including if the converted amount lost significant market value. This reversal is called a recharacterization (more on that below). The result of a recharacterization is that the conversion is treated as if it never occurred, for tax purposes. But only the amount credited to the Roth can be recharacterized. For instance, if we use the example above, only $80,000 would be available. You would still owe income tax on the $20,000, because it would be treated as a distribution from your traditional IRA. An exception applies if it has been at least 60 days since the conversion was completed. Under this exception, the amount withheld for income tax can be rolled over to the traditional IRA. Of course, this exception is useful to you only if you can come up with the funds out of pocket.

The amount withheld for taxes is subject to the 10% early distribution penalty unless the IRA owner is at least age 59 1/2 when the conversion occurs, or qualifies for an exception to the penalty.

5. Converting to just one Roth IRA

Another mistake, according to Picker, is converting your traditional IRA into an existing Roth IRA account. “Every conversion goes into a brand new Roth account,” he said. “You can consolidate later, after the recharacterization deadline.”

Indeed, many experts suggest that you convert your traditional IRA into as many Roth IRA accounts as possible, each with investments of a similar type. With Roth IRA conversions, Uncle Sam lets you switch back to a traditional IRA before a certain date should the value of the account fall below the original conversion amount.

6. Forgetting to consider a recharacterization

Not converting is one possible mistake. Not watching the value of your Roth IRA accounts after you’ve converted is a big mistake too, Keebler said. Indeed, there are some tax-saving opportunities that come when the value of your converted Roth IRA accounts falls significantly and you undo the conversion.

According to Appleby, when pre-tax amounts are converted to a Roth IRA, income tax is owed on that amount. This rule applies even if the market value falls below the taxable amount of the conversion. For instance, if you convert $100,000 in pre-tax dollars and the market value falls to $50,000, income tax is owed on the $100,000.

“The good news is that taxable conversion transaction can be reversed (recharacterized), if it is done by your tax filing deadline, including applicable extensions. The recharacterization can be done, even if your tax return has already been filed, as an amended tax return can be filed to reflect the removal of the conversion from the individual’s taxable income,” she said.

“Many fail to take advantage of this opportunity for various reasons including lack of awareness and missing the deadline, and as a result, pay a higher tax bill than they need to,” she said. “To prevent this from occurring, individuals should check the value of their conversions shortly before the deadline for recharacterizing and — if the market value has fallen significantly — instruct their financial institutions to recharacterize the amount.”

Appleby said the deadline for completing the recharacterization is the tax filing due date, plus an additional six months if the individual files for an extension by his tax due date. You can then re-convert the amount when eligible to do so.

In the example above, Appleby said that if the market value remains at $50,000, recharacterizing and then reconverting would result in the account owner owing a tax bill on $50,000 instead of $100,000.

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