3 Roth Conversion Mistakes Pre-Retirees Keep Making

Key Points

• Conversions to a Roth IRA should not be done in high-earning years.

• Investors should always pay their conversion taxes at the end of the year, not with their investable assets.

• Consider Medicare tax brackets before making conversions two years before age 65.

• The $23,760 Social Security bonus most retirees completely overlook ›

The tax consequences of your retirement savings decisions can make your head spin. You have employer-sponsored plans, regular IRAs (individual retirement plans), Roth IRAs, and plenty of other account types you can park your savings in. For investors on the path to a seven-figure retirement portfolio, decisions made today could mean the difference in hundreds of thousands of dollars in tax payments when you are in retirement.

One tactic many savers will use as they enter the pre-retiree age bracket (what you might categorize as the 50s and 60s, depending on the person) is converting funds from a traditional IRA to a Roth IRA. This can help you avoid paying capital gains taxes in retirement.

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However, there are many mistakes you can make as a pre-retiree converting your savings from an IRA account to a Roth IRA. Here are three common mistakes pre-retirees make, and how you can avoid making the same in your own portfolio.

Converting during high-earning years

A regular IRA is a retirement account that deducts your taxable income from the current year. A Roth IRA has no tax deductions at the time of deposit, but it can compound your wealth tax-free, meaning you pay no capital gains taxes on distributions. Each type of account allows an investor to deposit $7,500 in total each year (in total, not to both accounts), and distributions can be made after the owner turns 59 1/2.

Regular IRAs can be helpful to deposit into in high-earning years to lower your taxes owed to the IRS. However, they are suboptimal compared to a Roth IRA in retirement, as you have to pay taxes on any capital gains built up over the decades on any withdrawals.

This is where the Roth IRA conversion comes in. The government allows regular IRA owners to convert their accounts to Roth IRAs at any time, with no annual limit on the amount converted.

The only catch? A conversion is taxed at ordinary income in that calendar year. For a standard married household, your peak earning years may be in your 40s and 50s, meaning a conversion may be taxed at your high, progressive rate. This means anyone looking to convert should, as much as possible, wait until they have reached lower-earning years and spread out conversions over many years to lower their annual tax bill.

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Making improper withholding decisions

When a conversion is made, you can elect to have your brokerage pay the taxes on your distribution, or simply add the taxable income to your annual tax bill when you file your taxes.

In almost all scenarios, it is best to pay the taxes later, as it maximizes the amount converted to your Roth IRA, which is now sheltered from future taxes. For example, if you convert $100,000 to a Roth IRA and pay the taxes on your end-of-year bill, you will keep $100,000 in the Roth IRA. With the brokerage making the payment at an estimated 20% tax rate, only $80,000 will remain in the brokerage to compound tax-free.

Over time, this can be a huge difference. Assuming a 10% annual return over 20 years, $100,000 will grow into $673,000 that you will owe zero future taxes on. In contrast, $80,000 will only grow to $532,000, or a difference larger than the initial conversion.

Forgetting about Medicare

Another loop that unfortunately gets thrown into the mix is Medicare, which adults in the U.S. can start using at age 65. Your annual Medicare insurance premiums are based on your income, but with a twist: They are based on your income from two years prior to enrollment.

This means an investor should try to make their IRA-to-Roth IRA conversions before starting to take Medicare. If you make a large conversion at age 63, your monthly Medicare premium could jump by hundreds of dollars, which can add up in retirement. The sweet spot, if possible, is to convert your regular IRA funds to a Roth IRA before age 63.

Everyone's situation is different, but there are simple strategies you can use to minimize taxes paid on your retirement savings. An IRA-to-Roth IRA conversion can be one of these strategies, as long as it is executed intelligently.

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