Since the invention of the Roth IRA in 1997, retirement savers and financial advisors alike have been thrilled at the notion of a retirement savings vehicle that allows money to compound tax-free. The Roth gained even more popularity with the New Year when the tax laws surrounding the Roth changed making it available for all retirement savers, no matter their income. Prior to 2010, only individuals earning less than $100,000, single or married filing jointly, were allowed to convert to Roth IRAs. As of January 1, 2010, anyone saving for retirement can switch to a Roth. Who wouldn’t want to pay taxes up front and lock in today’s lower rates rather than wait until it’s time to withdraw in retirement and pay taxes at the future rates?
Although the hype and fascination of converting to a Roth is a popular strategy of today, many are not taking the time to understand whether or not converting makes sense for them and their situation. A Roth can be a powerful retirement savings tool, but understand that it may not be for everyone. The following four problems converters should understand and avoid in order to get the most out of their potential Roth IRA conversion:
Problem # 1: Converted, even if it’s not right for your situation
Just because you’re able to convert to a Roth doesn’t mean you should. For instance, taxes are due on the amount of money converted, although you can pay off this liability over a two-year period, it could still be an expensive decision. Dipping into your retirement account to afford conversion taxes should be avoided at all costs. Not only can you get penalized for doing so (this is addressed a little later), but also, you’ll run down your other accounts by taking money out to pay the taxes.
You should also consider your income tax bracket in retirement. If it’s going to be considerably lower then converting to a Roth might not make sense, since taxes owed are based on your tax bracket, and you might pay more today on the conversion than you’d pay on the withdrawal of funds in retirement – if you are in a lower tax bracket.
Problem #2: Converted the wrong way
A Roth conversion has penalty traps that result in converting the wrong way, but can be avoided if you’re aware of them.
If you converted but failed to do a direct transfer of your traditional IRA or 401(k), you will likely have to pay an early withdrawal penalty if you’re under the age of 59 ½. Also, if a check is issued in your name and you deposit the money into the new Roth account yourself, you’ll have to pay a 20 percent withholding tax. If your IRA or 401(k) custodian doesn’t allow a direct transfer, different rules apply (this is covered under Problem #3).
Also, if you rolled over your Required Minimum Distribution to a Roth, and are required to take an RMD from your traditional IRA or 401(k) the year you convert to a Roth, be sure to not rollover the RMD. If you do convert the RMD, you may go over the amount you’re allowed to contribute every year, which would result in a 6 percent excise tax for every year the excess amount stays in the account.
Problem #3: Converted ineligible funds
In addition to RMDs, there are a few other ways you’d get penalized for converting ineligible funds.
Waiting too long to put funds into a Roth makes them ineligible for conversion. The 60 day rollover mistake happens when a plan, such as an employer sponsored plan, does not allow a trustee-to-trustee transfer, aka a direct transfer, and the account owner is given a check. An account owner has 60 days to put the funds into another retirement account and after that they’re no longer viable for conversion.
As mentioned before, if you decide to withdraw funds from an existing retirement savings account to pay for conversion taxes, you will be hit with a 10 percent penalty tax as well as income tax. Pay the taxes out of pocket to avoid these hefty fees.
Problem #4: Converted without updating estate documents
Making sure your estate documents are up-to-date is crucial to the proper execution of your estate, especially when passing on your retirement accounts to beneficiaries. Failing to do so can result in your estate going through probate and paying estate taxes, ultimately leaving your heirs with exactly what you did not intend.
Be sure to obtain and complete beneficiary forms immediately after the conversion. Your Roth custodian should have the beneficiary designation forms you need, and you will need to fill them out and sign them in order for your funds to end up in the right hands after you pass. These forms don’t transfer from one account to the next.
If you weren’t specific in naming (designating) beneficiaries, there’s a good chance that your beneficiaries will end up in court and that means legal fees and stress.
As with any major financial decision, be sure to consult a qualified professional before converting some or all of your retirement savings into a Roth IRA. While you can undo the conversion if you made a mistake, it is best to do your research in the beginning so you don’t have to backtrack.
ABOUT CHAD SLAGLE & SLAGLE FINANCIAL ESTATE & RETIREMENT PLANNING GROUP
Chad Slagle is founder and president of Slagle Financial, an independent financial advisory firm. Slagle is an Investment Advisor Representative of Slagle Financial, LLC, a Registered Investment Advisor, and holds all required securities and insurance licenses to offer comprehensive financial solutions. With 14 years of experience in the financial services industry, Slagle counsels on a broad range of topics including retirement and estate planning, 401(k) rollovers, investment planning, and college funding strategies. He and his wife April, along with their four children, reside in Edwardsville. Slagle financial has offices in Edwardsville and Jacksonville, Illinois, as well as St. Louis, Missouri. For more information about Chad Slagle and Slagle Financial, please visit http://www.slaglefinancial.com/.
Chad Slagle is an Investment Advisor Representative of Slagle Financial LLC, a Registered Investment Advisor.