Roth Conversions Look Simple -- Until You Hit These 3 Hidden Traps

If you retire with savings in a traditional IRA or 401(k), you may be looking at a couple of unpleasant things. First, you'll have to pay the IRS taxes on your withdrawals. And while this shouldn't come as a surprise, it can be a nuisance and point of stress.

Secondly, with a traditional IRA or 401(k) plan, you can't just let your money grow indefinitely. You'll eventually be forced to take required minimum distributions, or RMDs, which could drive up your taxable income and have other unwanted consequences.

That's why many people opt to do a Roth conversion ahead of retirement, or early on in retirement before RMDs start. With a Roth conversion, you move funds from a traditional retirement account into a Roth IRA.

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With a Roth IRA, your withdrawals are tax-free, and gains in your account get tax-free treatment as well. Just as importantly, Roth IRAs don't force savers to take RMDs.

But if you're going to do a Roth conversion, it's important to go about it strategically. And that means avoiding these hidden traps.

1. The tax bracket cliff

One of the biggest mistakes you might make in the course of a Roth conversion is moving too much money into a Roth IRA in a single year and unintentionally pushing yourself into a higher tax bracket.

A Roth conversion adds to your taxable income, which can increase your federal tax rate on not just the converted amount, but potentially on other income as well. So your goal should be to "fill up" lower tax brackets strategically without spilling over into higher ones.

For example, let's say that based on your conversion amount, you have room left in the 22% tax bracket to move money into a Roth IRA. Rather than just do a massive conversion, it could pay to spread that conversion out over a few years and convert just enough money per year to stay within that 22% bracket.

Once you go into the next bracket, you face higher taxes. That reduces the overall benefit of a Roth conversion.

2. IRMAAs

At age 65, you're eligible for Medicare, which charges a monthly premium for Part B. Many Part D drug plans also charge enrollees a premium. But those premiums could cost you a lot more if you get hit with IRMAAs, or income-related monthly adjustment amounts.

IRMAAs are based on your income from two year prior, which means a large Roth conversion this year could result in much higher Medicare costs two years from now. And those added costs aren't small.

This year, the lower IRMAA tier for Part B is $81.20. But for people with very high incomes, IRMAAs could add as much as $487 a month to the cost of Part B.

When doing your Roth conversion, be mindful of IRMAA thresholds. You may want to keep your conversions just below the limit where surcharges on Medicare premiums might apply.

3. Taxes that erode the benefit of a conversion

When do you a Roth conversion, the sum you move into a Roth IRA becomes taxable that year. And it's important to have a plan for tackling that tax bill.

You might assume that you can just pay your taxes right out of your retirement savings. But that partially negates the benefit of a conversion.

A better bet? Aim to pay those taxes from cash or a taxable brokerage account. This is an especially important thing to plan for if you intend to start doing Roth conversions before turning 59 and 1/2.

Let's say you begin Roth conversions at 54 and intend to take a withdrawal from your 401(k) to cover the tax bill. Guess what? At 59 and 1/2, you're not eligible for penalty-free withdrawals. So if you take money out of your 401(k) to pay the IRS, you could end up losing an additional 10%.

Roth conversions are a great way to reduce your tax burden later in life and steer clear of RMDs. But it's important to plan for them carefully. Avoiding these three traps could help you make the most of a Roth conversion without unwanted consequences.

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