Transcript:
Hey, guys. Mike Frontera here back with another retirement theory video. So if you've watched any of my videos before, you know that I am a huge fan of Roth conversions. I think that they are one of the most powerful tools that you can use when planning your retirement distributions. When done right and in the right circumstances, and when they are, you can save tens or even hundreds of thousands of dollars across your retirement. Thus extending how long your money lasts or allowing you to live on more money in retirement and enjoy the things that you want to do. And at the end of the day, isn't that the whole point?
But there are a lot of scenarios where Roth conversions make no sense at all. And there are a ton of mistakes that can be made when doing them. So today I'm going to go over five of these mistakes. Probably the most common mistakes that I see when completing Roth conversions. So the big theme on today is going to be unintended consequences. I mean, the purpose of doing a Roth conversion is that when you have money in a traditional IRA or a 401k, some sort of pre account that you have not yet paid taxes on at some point to get enjoyment out of that money you have to pay taxes on it. What the Roth conversion allows you to do is to you to pick the time and the amount of how much you're going to take out and move that money from that pretax account to a tax free Roth account, paying the tax is on that distribution when you wish.
The theory behind it being I am going to choose the amount and the timing of when I want to pay those taxes. So I am not forced to pay those taxes later at a higher rate.
Mistake 1: Unintended Consequences
So one of the first things I see is when a Roth conversion has not only tax consequences, but also has these other sort of side effects or other unintended consequences after doing the conversion. So some of them that come to mind most prominently would be, paying Irma on your Medicare, which is the income related monthly adjustment amount, which if you look here, I'll show you a pull up income tables here, okay. For where you would pay additional premium on your Medicare. And you can see once you hit these thresholds two years later, you're going to be hit with a surprise notice from Medicare, saying you have to pay this additional premium because your income exceeded this amount.
So it's not a tax per se, but it is a penalty that you're paying. Once your income hits a certain threshold, the other health care related, and this would be for people who retire, before Medicare age and have to get a policy, on the health care exchanges. Is your income affects how much premium you pay on those health care exchange health insurance policies. Let's talk about those, ACA, Affordable Care Act, health care, premiums and how they're impacted by Roth conversions. The subsidies that you receive in those subsidies, they call them, a premium tax credit. And so that tax credit is applied against the premiums that you owe. These are based on income in relation to the federal poverty level. Here's what it looks like, the what the current federal poverty level is. And once you hit 400% threshold, your federal poverty level, basically you're paying an 8.5%, increase in your premiums until that subsidy totally goes away.
So how does this work in practice? Well, what happens is, if you tell the health care exchanges that your income is, say, $70,000 your income comes out where toward the end of the year, you see, it's only $65,000. And if you look, if you're a married couple, you're in a very low tax rate right there. So you might say, geez, this is a great opportunity for me to do some Roth conversions. Well, what will happen is you will not only pay that amount of income tax, but you will also increase, your ACA premiums, or conversely, you will be, reducing the the amount of that advanced premium tax credit. And so when you go to do your taxes in the following spring, you will likely have to pay back a bunch of that tax credit that you received throughout the years to offset your premium.
Mistake 2: Losing Income-Based Program Eligibility
Now I've mentioned two health care related changes, but there are many other income based programs that a lot of retirees are trying to qualify for, that they can either lose in part or in whole. So I've had clients that are eligible for income based assistance on their prescription drugs or on their out-of-pocket health care costs or on their property taxes. Or even on their utilities. And all of these programs are based on what your income is. And so when if your income is low, but you make a large Roth conversion, when you go to apply for these benefits in the following year, they're going to say, you make too much money and you may lose those benefits. And so it's very important. And the main takeaway with this mistake is be 100% aware of what programs that you are, taking advantage of that are income based. And what type of health insurance that you're receiving, whether it's Medicare or a health care exchange plan.
Mistake 3: Mismanaging Backdoor Roth Contributions
Okay, the next one is, one that I've started to see a little bit more of in the last couple of years. And this is, goes around a lot online. I see a lot of articles and information about, what's called backdoor Roth contributions or backdoor Roth conversions and basically how it works. Is there are income limits for making contributions to a Roth IRA is there are income limits for making contributions to a Roth IRA. Now, if your income exceeds those limits and you still want to make a Roth contribution, you can make those contributions sort of indirectly. So the basics of backdoor Roth IRA is that you contribute to a traditional IRA, which has no income, limitations. These are generally not going to be deductible contributions if you have a 401(k) plan at work. And then you immediately convert that traditional IRA. Since you didn't get a deduction for that traditional IRA contribution, you don't pay any tax on that money to convert it to a Roth IRA. And now you end up with money in the tax-free Roth where you previously weren't able to make that contribution. And now you can.
But the main mistake here is if you have other IRA assets, when you make this a backdoor Roth IRA, the IRS is going to treat all of those IRAs as aggregated together. Let's take a look at a quick example here. So we have Gerry who has a $100,000 IRA. He makes too much money to contribute to a Roth. So he wants to do this backdoor Roth. So he opens a new IRA and contributes $8,000 to it. Now he goes to convert the $8,000 expecting to pay no tax on the $8,000 he already put in because he got no deduction for it. However, the IRS has other plans in mind for him.
So they look at the entire IRA balance again. They aggregate it all together. So he's got his $8,000 in his new IRA plus the $100,000 in his old IRA. Right. So they look at that and they say 7.5% of that total of that $108,000 total is after-tax money, 92.5% is pre-tax money. So that means his conversion is gone. And it doesn't matter what money he converts, he can convert that new IRA, that $8,000. It's going to contain 92.5% pre-tax money. And now the worst part is Gerry is always now going forward, we'll have to calculate out what portion of every withdrawal in the future is pre-tax versus after-tax. Until all of his IRA money is spent out. It is a tax, an accounting nightmare that never ends until your IRA is gone.
Mistake 4: Converting Too Early in the Year
Okay, now, this next mistake is a very easy one to avoid. It is converting too early in the year. So why is converting too early in the year such a big deal? Well, back before the Tax Cut and Job Act of 2017, you were able to perform what's called a recharacterization, which is basically the undo button of a Roth conversion. So if you made a conversion and then some point in the year, your income got much higher than expected, maybe you had an emergency and you had to take out a bunch of money out of your IRA, you were always able to undo that conversion. That is no longer the case.
If you convert early in the year, and it turns out later in the year, you get this other jump in income, you cannot undo that conversion. So unless there is some other exception, we generally will do all of our conversions toward the very end of the year so that your income picture is much clearer, and there is a much smaller chance for a surprise amount of income to screw up your tax situation.
Mistake 5: Not Completing Required Minimum Distributions (RMDs) First
Finally, one of the biggest mistakes that I see is for people who are receiving their required minimum distributions and still want to make a Roth conversion. So this is a relatively new rule, in fact, was just finalized last year, which is that you must satisfy your required minimum distributions on all of your IRA accounts before doing any Roth conversions. The IRS will consider that the first money out of your IRA is always going to be your required minimum distributions. So what happens is let's say in October you decide that you want to convert $10,000 of your IRA to a Roth, but you have not finished your required minimum distribution. So because required minimum distributions cannot be converted to Roth IRAs, the IRS is going to treat that money that was converted as an excess contribution to your Roth. And you are going to be assessed a 6% penalty every year that that money stays in that Roth IRA.
Worse, if it causes you to not have actually taken your required minimum distribution, you're going to pay a 25% penalty on the amount that you should have taken out first. So this is a big one. Be 100% sure that when you convert money from your IRA to your Roth and you are of required minimum distribution age, that you satisfy your required minimum distribution first before doing your Roth conversions.
I love the Roth conversion as a retirement distribution strategy tool. It is one of the most powerful tools out there and can make a huge difference in the amount of income that you're able to use for yourself. However, with great power comes great responsibility. So I just highlighted these five common mistakes. But there are many more out there. So you really need to be careful when doing Roth conversions. They can make a great difference for you, but it is one of those measure twice, maybe measure thrice and cut once type of strategies. Got questions for me? Let me know. Come visit me at RetirementTheory.com or send me an email at Mike@RetirementTheory.com. Thanks for watching. See you next time.