So, you’ve decided to commit to a Roth conversion. Before you begin submitting your requests to your current custodian, there are a few things to know. There is a right way and time to do a Roth conversion. When you decide to do a conversion, you want to do it strategically to avoid a huge tax bill. Directed IRA has been assisting people with their conversions for years, and we’ve identified 5 common mistakes clients make when they elect to do their Roth conversions. (Download our Beginner’s Guide: How to Self-Direct Your IRA)
Let’s jump in.
Mistake #1: Not Being Strategic to Minimize Your Tax Burden
We see clients regularly request a conversion of their full, pre-tax account. Converting the entire account at a time can be costly. Clients do not have to convert everything at once or in one tax year. By breaking up the conversion over time, they lessen their tax burden and spread it out over a few years. This is referred to as “chunking.”
If you are unsure how much to convert to complete a successful conversion, contact the team of tax attorneys at KKOS Lawyers or consult with your CPA. They can walk you through your specific tax scenario to show you the best way to complete a neutral Roth conversion (little or no taxes paid may be possible).
The trick is to look at your tax bracket and convert just enough before you’re pushed into the next, higher tax bracket. Your CPA can get specific with you on how much to convert while identifying additional deductions you qualify for through your business, investments, and more to minimize your tax bill.
Learn more about Traditional IRAs and how they differ from Roth IRAs.
Should you convert your IRA over to Roth all in the same year? No. Converting your entire pre-tax account at once can lead to a significant tax bill. Instead, break up the conversion over several years, a strategy known as “chunking.” Consult a CPA or tax attorney to determine the optimal amount to convert each year without moving into a higher tax bracket.
Mistake #2: Paying Taxes Due Out of Traditional Accounts When You Convert
If you have the resources, do not pay your Roth conversion taxes with your IRA dollars! Taxes are not due at the time of conversion, although you can pay them at the time. Taxes are due when you file taxes for the year in which you did the conversion. This can give you several months to plan for how you will pay the taxes using personal dollars instead of your tax-deferred and now tax-free IRA dollars, depending on when you request the conversion.
Should you use IRA funds to pay conversion taxes? No. Do your best to avoid using IRA funds to pay conversion taxes. Taxes are due when you file for the year of conversion, giving you time to plan and pay with personal funds. Preserve your retirement dollars for investments, and your accounts will grow faster.
Learn how to open an IRA account to start your conversion the right way.
Mistake #3: Assuming You’ll Make Less Next Year, You Wait to Convert
We hear this scenario every day… clients choose not to convert this year because they assume they will make less the following year. As you can imagine, this sometimes works in the client’s favor, but for the majority of clients, it simply delays the ability to move things to a tax-free position in a Roth IRA.
Begin your conversion today, and don’t delay, as you can “chunk” the conversion out over the next few years (as discussed under Mistake #1).
Your Roth conversion can be tax-neutral. You can make this happen by chunking your IRA (converting a small portion of your pre-tax funds over a few years) and starting to earn tax-free now instead of several years from now… or never if you get analysis paralysis.
Should you wait for a lower income to convert your Roth? Waiting for a lower-income year often delays tax-free growth in a Roth IRA. Start your conversion now and spread it over several years to maximize benefits. Remember, there are no income limits for conversions. Learn more about how Roth IRAs work.
Mistake #4: Trying to Convert on April 15th for the Prior Tax Year
Conversions are taxed in the year in which they are processed. If you request a conversion on March 1st, taxes on the converted amount, if applicable, will be due when you file taxes the following year.
Tax time is stressful for many people, but we want you to be ready so you don’t have to prepare for tax time. Meet with your tax professional as early as you can so you can map out your strategy and save more efficiently.
People need to meet with their tax professionals in January-March before the April 15th tax deadline. If you meet with your tax professional, you must also remember that any conversions you make in those months will be taxed and addressed the following year, NOT in the year you make the request.
This is a common misconception, as you can contribute to an IRA for the prior year until April 15th.
Should you wait until April 15th to convert your Roth IRA? No. Conversions are taxed in the year processed. Meeting with your tax professional early allows for better planning. Conversions made in the early months are taxed the following year, not the prior one.
Learn more about Roth IRA funding and timing to ensure you don’t miss key deadlines.
Mistake #5: Thinking There is a Single “Easy” Button
Although the overall Roth conversion process is quite simple, we see our clients try to skip a few steps, which can cause unnecessary delays in completing a conversion.
To convert to a Roth IRA, you must establish one first. We cannot move the assets from your pre-tax account without having somewhere for them to land first. If you already have a pre-tax account with a Directed IRA, you will just need to establish a new Roth IRA before you submit the Roth conversion request.
In addition to having a Roth IRA ready to receive the converted assets, you will also want to meet with your CPA or other tax professional to determine how much you can convert before bumping yourself into a higher tax bracket. This will ensure you can convert while keeping it tax-neutral and identify additional strategies to reduce your tax bill.
If you are unsure where to start, contact Directed IRA for further guidance and step-by-step instructions on how to convert your account in the most beneficial way for your tax situation.
Schedule a call today for personalized guidance.
Is it easy doing a Roth Conversion? While the process is quite simple, skipping steps and making mistakes is easy. Ensure you have a Roth IRA established before converting assets. Consult with your CPA to avoid moving into a higher tax bracket. Directed IRA can provide guidance and step-by-step instructions.
Bonus Mistake: I Have Real Estate in My IRA, and I Can’t Convert It
Whether your IRA is liquid or invested, you can convert the holdings. That’s right—even if you own a property precious metals or do a private loan through your account, you can still convert it at any time. This is called an in-kind Roth conversion. To convert illiquid assets, there is one additional step in the process:
Converting Cash:
- Establish a Roth IRA
- Submit the Roth Conversion request.
Converting Assets:
- Establish a Roth IRA
- Obtain a valuation or appraisal for your IRA’s assets
- Submit the valuation and Roth Conversion request.
For example, if your IRA holds real estate, you must obtain a recent appraisal (dated within the last 60 days). Once you provide us with the updated value, you can convert all or some of your holdings. This ensures we convert the proper amount and value for you and allows us to report it accurately to the IRS on your behalf.
We hope this helps you navigate the world of Roth conversions!
Whether converting cash or assets, a Roth conversion offers significant long-term benefits. Avoid common mistakes by planning strategically, consulting professionals, and following proper steps for your individual situation.
For more insights, explore our Self-Directed IRA resources or book a call to start your conversion today.
