A Roth conversion can be a great way to save on taxes in retirement, but it’s important to avoid making common mistakes. In this article, we will discuss five of the most costly Roth conversion mistakes that can derail your strategy. Make sure you understand the implications of each decision before you convert your Roth IRA!
Having a haphazard approach to the conversion process
Too many individuals choose to convert their Roths because they believe it is always a good strategy to employ. Without taking the time to figure out the best strategy for their needs, they may end up paying more in taxes than if they had not converted to a Roth IRA.
One way this plays out is if they convert too much of their traditional account in one calendar year. This could push them into a higher tax bracket, forcing them to pay more tax than is necessary.
Another way this plays out is that they convert too little from the Traditional IRA to the Roth IRA and have significant Required Minimum Distributions (RMDs) once they do retire. Large RMDs can again push someone into higher tax brackets, forcing them to pay more tax than is necessary.
Using Funds in the Roth IRA to Pay Taxes on the Conversion
When you convert a traditional IRA to a Roth IRA, you will have to pay income taxes on the amount converted. It will be considered income for the year. If you take money out of the Roth IRA to pay for those taxes, you will have less in that Roth, and therefore less money that can grow tax-free.
A better approach is to use funds from taxable accounts to pay for the taxes on the Roth conversion.
Forgetting to Consider Asset Location Strategies for the Roth
Not to be confused with asset allocation, asset location is just as important a tool to maximize your long-term, after-tax returns, particularly when using a Roth IRA account.
I have written a detailed article that you can read, but the basic idea is this. If you own assets with high growth potential, such as stocks, you will likely want to locate them, hold them, in your Roth IRA. By doing this, you maximize the benefits of that account’s tax-free growth. Conversely, assets that have lower expected returns, such as bonds, are best held in other types of accounts, not in a Roth IRA.
The important thing here is that after a Roth conversion has taken place, it is critically important to evaluate the locations of all of your investment assets and rebalance or relocate assets as is necessary to get the maximum benefit out of a Roth IRA.
Not Seeking Professional Help
Failing to seek professional help when you are considering a Roth conversion can be costly. A financial advisor can help you understand the ins and outs of a Roth conversion and how it will impact your taxes both now and in retirement.
The second part of this mistake is using the services of someone who is not a fee-only financial advisor. Many so-called professionals will try to sell you products, such as annuities, that are not in your best interest.
A fee-only financial advisor is someone who works for you and only charges a fee for their services. They do not sell products and they do not receive commissions. This type of advisor is much less likely to give you bad advice because their only motivation is to help you succeed.
Making any of these mistakes can be costly in terms of both time and money. Be sure to do your research and seek professional help before making any decisions about converting to a Roth IRA. With careful planning, a Roth conversion can be a great way to save for retirement.
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