Three Costly Roth IRA Conversion Mistakes

Roth IRA ConversionMany people took full advantage of a Roth IRA conversion in 2010, thanks to the new no income limit rule and a one time tax payment change.  But were those 2010 Roth conversions the best choice for the money? Is there time to go back?  What should you be considering for any future Roth IRA conversion?

Certainly there are benefits to a Roth IRA conversion.  The two biggest being tax-free retirement income and no minimum distribution requirements.  In order to get the benefits of a Roth IRA, there are immediate tax costs.  If these benefits don’t outweigh the costs involved, a Roth IRA conversion is wasted money for the wrong person.  So, consider these three reasons a Roth IRA conversion is a mistake.

1. A Lower Retirement Tax Bracket

When you do a Roth IRA conversion, the entire amount converted to a Roth IRA is taxed at your current income tax rates.  If you’re sitting at 10% or 15% it might be worth it, if you’re pushing for a better, higher paying job.  As you move up in tax brackets your chances of being in an even higher tax bracket in retirement diminishes.

How much income do you plan on having in retirement?  More than you’re making now or less?  Most people can expect to make about 75 – 85% of their current income.  Which means, day one of retirement, you can expect to pay taxes on about 20% less income than when you were working.

The only reason you should consider a Roth IRA conversion is if you know with 100% certainty that your retirement income will be higher than it is now.  Which leaves the unemployed and maybe a few 20 and 30 somethings that haven’t started moving up the income ladder.  It also means that many people are already in their max tax brackets or close to it.  Why would you pay the highest tax rate now instead of waiting to pay a lower tax rate when you retire?  It makes no sense and it’s a waste of money.

2. Can’t Afford the Taxes

Taxes must be paid on the amount that you would convert to a Roth IRA.  Depending on your current tax bracket and the amount you convert, those taxes can add up to large sum.  Whether you can afford to cover the tax costs should be a big deciding factor in a Roth IRA conversion.

You’ll need the cash on hand to cover all the taxes.  Borrowing or using money from inside the IRA won’t cut it.  Taking on debt to cover any taxes is not a smart choice.  If you’re thinking of using money inside the IRA to cover the taxes, think again.  You’ll be hit with the 10% early withdrawal penalty if your under 59½.  Which only loses you more money.

3. The Balance Dropped In Value

One of the benefits of a Roth IRA conversion is having the option to undo or “recharacterize” the conversion back to a traditional IRA.  This benefit allows you to undo an unwanted conversion or possibly save money if the balance drops in value.  Not taking advantage of this do over could cost you money.

The taxes you pay are a percent of the balance of the IRA.  If that balance drops in value, you can undo the conversion and reconvert later at the lower balance.  A lower balance means less taxes you have to pay.  A significant drop in the balance can mean big savings.

Undo a Roth IRA Conversion

There are a few things to consider before you undo a Roth IRA conversion.  First, you must wait 30 days before reconverting and it can’t be done in the same tax year as the original conversion.  So there is some risk involved with having to wait.  Second, if the balance grows during that waiting period, the process could backfire and you could end up paying more taxes.  Third, there is a deadline to undo a Roth IRA conversion, don’t put it off till the last-minute.

A Roth IRA conversion can be a very beneficial tool for retirement savings.  Before you make a Roth IRA conversion, consider these three potential mistakes that could cost you in the long run.


  1. says

    Interesting post, and good considerations. You make a good point about being able to afford the taxes. Unfortunately for some people, they might actually try to use money in the IRA to cover taxes, which is a terrible move that just wreaks havoc with the whole thing. No way anybody should pay a 10% penalty right of the top, and best to think of these funds as truly retirement funds.

  2. says

    I guess the benefit to this, and many other financial “tools” comes down to education and balance. Know your costs before hand so you can really weigh them against the benefits and find a balance that works for you.

  3. says

    We are currently in a low income tax bracket, and I was looking to take my retirement from my former employer and roll it into a Roth IRA. However, it would cost too much in taxes to roll it over, so I had to choose a different plan.

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