There are plenty of reasons your clients may be interested in converting their traditional IRAs to Roth IRAs. Higher-income clients are no longer excluded from converting their accounts, and income taxes due on the conversion can be spread over two years. There are several missteps, however, that could derail a successful conversion. Robert Powell, writing for MarketWatch, describes six mistakes to avoid when converting a traditional IRA to a Roth.
1. Neglecting to do the conversion. Powell cites Beverly DeVeny, an IRA technical consultant with Ed Slott and Company LLC, who asks, "Why would you not want to pay taxes today at known — probably very low rates — to get tax-free income at a later date (probably at higher and maybe much higher rates)?" She recommends investors who don't want to convert their entire IRA at once at least convert a portion of it.
2. Failing to understand tax consequences. Powell calls Roth IRAs the opposite of traditional IRAs. The Roth IRA is funded with after-tax dollars, and distributions aren't taxed; the traditional IRA uses pre-tax dollars and distributions are taxed. "The additional income from the distribution of the traditional IRA would most likely bump you into a higher tax bracket," he writes.
3. Converting when clients are likely to be in a lower tax bracket. If it's likely that your clients will slip into a lower tax bracket, they should hold onto their traditional IRAs.
4. Having taxes owed withheld from the transaction. Powell turns to Denise Appleby, chief executive of Appleby Retirement Consulting, who warns against withholding taxes from a conversion. The amount withheld reduces the conversion amount, and is subject to the 10 percent early distribution penalty, unless your clients are older than 59 1/2 when they convert the accounts. Furthermore, if clients decide later that they want to reverse the conversion, they can only reverse what was originally credited to the new Roth IRA. If anything was withheld for taxes, that portion would be taxed as a distribution from a traditional IRA.
5. Converting to just one Roth IRA. Powell suggests that investors convert traditional IRAs into as many Roth IRA accounts as possible, with investments of a similar type. "With Roth IRA conversions," he writes, "Uncle Sam lets you switch back to a traditional IRA before a certain date should the value of the account fall below the original conversion amount."
6. Forgetting to consider a recharacterization. If the value of the converted Roth IRA falls significantly, your clients have some tax-saving opportunities if they undo the conversion. Income tax is owed on the entire pre-tax amount that was converted, even if the market value falls below the original amount.
"The good news is that taxable conversion transaction can be reversed (recharacterized), if it is done by your tax filing deadline, including applicable extensions," according to Appleby. "The recharacterization can be done, even if your tax return has already been filed, as an amended tax return can be filed to reflect the removal of the conversion from the individual's taxable income."
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