When residents of Missouri learn that Roth retirement accounts can provide tax-free income, they may be tempted to quickly convert money from traditional retirement accounts to Roth accounts. However, without careful planning—including an analysis of current and future tax rates—that rush to convert can result in an unexpectedly expensive tax bill, according to a recent Financial Advisor article, “Roth Conversion Mistakes, Who Knew?”
Before completing a Roth conversion, there are several important factors to consider. For example, additional taxable income can affect how much of your Social Security benefits is subject to income tax. Required Minimum Distributions (RMDs) can also increase Medicare Part B and Part D premiums because of the income-related monthly adjustment amount (IRMAA).
Have you considered how a Roth conversion could affect your Social Security taxes or future Medicare premiums?
The potential advantages of a Roth conversion can be significant. If you have the resources to pay the taxes resulting from the conversion and your heirs eventually inherit the Roth account, they may be able to benefit from tax-free growth during the applicable distribution period. In this way, a Roth conversion can become part of a multigenerational wealth-transfer strategy.
But the potential benefits need to be weighed against the tax consequences and your overall estate and retirement plan. Missouri residents considering a significant Roth conversion may benefit from consulting with Missouri attorneys who can help evaluate the estate-planning, tax, and wealth-transfer issues that may accompany the decision.
Could a Roth conversion fit into your broader estate plan, or might another strategy better accomplish your goals?
Avoiding Procedural Mistakes
Some Roth conversion mistakes are simply procedural. For example, someone might miss the December 31, 2026, deadline for completing a 2026 Roth conversion because they mistakenly believe they have until April 15, 2027—the deadline generally associated with making 2026 IRA contributions. These are different deadlines, and confusing them can have costly consequences.
This distinction is particularly important for individuals using a “backdoor Roth” strategy, in which a nondeductible contribution is made to a traditional IRA and then converted to a Roth IRA. The tax calculation for a Roth conversion takes into account the year-end balances of the taxpayer’s traditional IRAs. That can include SEP-IRAs and SIMPLE IRAs, not merely the account being converted.
This issue can arise when someone has a small IRA left over from a former employer that they have forgotten about. What appears to be a minor oversight can substantially change the tax consequences of the conversion.
Do you know what other traditional IRA balances could affect the tax treatment of a backdoor Roth conversion?
Another potential mistake involves tax withholding. Income taxes withheld from a Roth conversion are generally treated as a taxable distribution. For an account owner under age 59½, the withheld amount may also be subject to the 10% early-withdrawal penalty unless an exception applies.
Similarly, if you complete an IRA-to-Roth conversion and choose not to have taxes withheld, you should not forget about estimated tax payments. Failing to make required payments can result in an underpayment penalty.
Don’t Let the Tax Bill Stop the Planning
One of the most expensive mistakes may occur when someone understands that taxes will be due on a conversion but decides against converting because the anticipated tax bill exceeds the cash currently available to pay it. Depending on the individual’s circumstances, a taxpayer over age 59½ may sometimes be better served by completing the conversion and paying the resulting taxes rather than abandoning the strategy altogether.
The right decision depends on numerous factors, including income, age, retirement assets, tax rates, Medicare considerations, estate-planning objectives, and the needs of future beneficiaries.
What could happen to your retirement and estate plan if you focus only on today’s tax bill instead of your long-term objectives?
Because Roth conversions can have consequences extending well beyond the year of the transaction, they should be considered as part of a comprehensive financial and estate plan. Financial and tax professionals can help evaluate the numbers, while our St. Charles, Missouri attorneys can provide guidance regarding estate planning, beneficiary designations, trusts, and other legal considerations.
A thoughtful review before converting retirement assets can help you avoid preventable mistakes and determine whether a Roth conversion truly advances your long-term goals. Secure a complimentary phone call to discuss your estate planning concerns with one of our attorneys.
Reference: Financial Advisor (Dec. 1, 2024) “Roth Conversion Mistakes, Who Knew?”