a Roth conversion is a strategy where you move traditional SEP or rollover IRA funds into a
Roth IRA for tax-free future growth anyone can do it no matter your age or your income limit
so the younger you are when you do it potentially the larger the benefit they're even more powerful
when converted in a down Market because all that potential growth in the future would now be in a
tax-free Roth IRA but there are ways you can get tripped up so in this video I'm going to
go over what I think are the five most common conversion mistakes so you don't make them hey
I'm Colin Exelby and I provide financial planning for business owners and their families that just
makes sense I own the financial advisory practice Celestial Wealth Management and provide advice
virtually to clients all over the country now before I reveal the number one mistake that many
people make when performing Roth conversions it's import important to point out important
disclosures the information in this video is for educational purposes this is not specific
financial planning health insurance or investment advice in addition everyone's tax situation is
different you should discuss your tax situation with a qualified Tax Advisor before implementing
any planning strategy okay now that that's out of the way the number one and by far the most
often made mistake is not knowing what's called the Pro-Rata rule Roth conversion Pro-Rata is
one of the most searched for terms on Google about conversions so that tells me that many
people don't understand it many financial planners many DIY investors and CPAs don't understand this
rule so here's the deal IRAs may contain assets that are pre-tax but also after-tax contributions
if your entire IRA is pre-tax then the entire conversion version is taxable that's easy but
what if it isn't many people mistakenly think they can just pull their after-tax contributions out of
the IRA and convert those to a Roth without tax consequences. Uh no you can't. The IRS is smarter
than that and will come after you for back taxes and potential interest and penalties if you try it
when performing a conversion a portion of both the pre-tax and post-tax money comes out of the IRA
it is not only the post-tax money that's what's called the pro router rule here's how it works
let's say you've accumulated a $500,000 IRA you made too much money to fund a Roth IRA because
of the annual income limit so each year you put in an annual after-tax IRA contribution let's say you
contributed forty thousand dollars over the course of a decade in after tax contributions now let's
say that you want to do a thirty five thousand dollar Roth conversion many people mistakenly
think that one hundred percent of that thirty five thousand dollar conversion is tax-free because it
is below what they contributed and that is where the big mistake occurs according to that Pro-Rata
rule only eight percent of the IRA balance is after tax contributions forty thousand dollars of
contributions divided by a five hundred thousand dollar balance is eight percent so that also means
that only eight percent of any conversion made would be non-taxable and the other 92 percent
is taxable in this example only eight percent or twenty eight hundred dollars of the thirty five
thousand dollar conversion is tax free the rest is fully taxable in this this second example say you
have a two hundred thousand dollar IRA balance and you contributed sixty thousand dollars in after
tax contributions that ratio is thirty percent but what if a bear market caused the balance to drop
by fifty percent and the balance in the IRA is only one hundred thousand dollars well the Silver
Lining is that by converting now sixty percent of the conversion is tax free and only forty percent
is taxable That's The Power of converting during a down Market if you have after tax funds in an
IRA don't forget about the pro router rule when doing a Roth conversion you may owe more or you
may owe less than you think once you factor it in okay the number two Roth conversion mistake
is actually not converting enough assets while you're young too many people mistakenly believe
that they will be in a significantly lower tax bracket in retirement when they are no longer
working for some people this is definitely true if you earn a high W-2 income like 300K 400k or
500k and don't own a business this may be true but for many people they will actually be in the same
or maybe even a higher tax bracket in retirement before you say this guy is nuts let's think about
this for a second let's assume you are 72 years old your future self and have been retired for a
few years you saved well over your life invested that money and your pre-tax retirement account
grew to a million dollars let's also assume that you worked hard and earned the maximum
social security benefit $4,194 dollars a month at 70 based on current rates that's essentially $50,000 a year all right now let's assume that you have some savings that are set aside and some
non-IRA Investments and you make a modest five thousand dollars from dividends capital gains
and interest your mandatory IRA distribution or RMD from a one million dollar IRA in 2022 is $36,496
So that means without any rental property income no pension and no part-time income you
have $83,996 dollars in income because fifteen percent of your Social Security will be tax-free.
that puts you at the top end of the 22 percent tax bracket if you're single and real close to the 24%
bracket where you're taxed the same as someone making a W-2 wage up to one hundred and seventy
thousand dollars but wait Colin I'm married I have different rates yes you do but you also
probably have retirement accounts for your spouse and social security for them so your income will
be even higher and this doesn't even include the potential for higher tax rates in the future hey
my point here is that assuming you will be in a lower tax bracket in retirement is not clear-cut
and for many people they may be in the same or a higher bracket so it's my opinion that people
are actually converting less than they should be whether a conversion makes sense is really a
case-by-case basis but in general if you're in the 22 bracket or less it probably makes sense
to take a advantage of raw strategies okay the number three mistake I see people make
when doing Roth conversions is forgetting about the IRMAA penalty when you're age 63. what's IRMAA?
IRMAA is essentially the Medicare surcharge on high income earners your Medicare insurance premium is
based off your income two years prior so at age 65 when you become eligible it will be based off of
your income when you're 63. and Roth conversion income is included in that calculation if you
want to learn more check out my video on why you want to be mindful about that mean old lady IRMAA
your Medicare premiums can be significantly higher in retirement because if you convert significant
assets at age 63 and over so be mindful of what those levels are if you go over by just one dollar
your entire Medicare premium increases and not just for you but if you're married also your
spouse in my experience many CPAs, many DIY-ers, and many financial advisors aren't aware of what
those levels are and how they can impact your planning so take notice the number four biggest
mistake I see is converting the entire Ira in a given year some people say just bite the bullet
do it all at once and never worry about it again and while there is some wisdom in this approach
converting too much in a single year can push you into a higher marginal tax bracket for many people
spreading out conversions over three or five or seven years can allow you to convert funds at much
lower tax rates keeping more money in your pocket or if your income Falls in a certain year because
of large write-offs or a reduction in income due to maternity leave or a recession speeding up a
larger conversion in that year can make a lot of sense so be mindful of your income and tax
bracket levels the number five biggest mistake that I see is not knowing about the five-year
rule what's that the five-year rule requires that you wait five years before withdrawing even one
dollar of your converted balance if you are under age 59 1/2. Now like I said, anybody can make
a conversion no matter what your age but if you take any money out of that converted money before
the five years are up and you are under 59 1/2 you pay a 10% penalty on those funds if you're
over age 59 1/2 then you are the exception to this rule because you aren't subject to that
penalty each conversion has its own five-year clock and that clock starts on January 1 of the
year the conversion is done so if you convert in November it's treated as if you converted
in January of that same year a nice Advantage for conversions late in the year you want to make sure
that if you are under age 59 and a half when you convert them that you will not need them for at
least five years which should be the point anyway because you want the converted funds to grow I
hope now that you have seen this video that you will not make any any of these five mistakes and
make sure to watch this video next to learn even more about the pros and cons of Roth conversions