Roth IRA Conversion Week: Social Analysis and Final Thoughts

Our Roth Conversion Week detailed many facets of the Roth conversion conversation ("Is a Roth conversion right for me?"), the advantages and disadvantages of conversions into Roth IRAs and Roth 401(k)s and finally, the Top 10 Roth conversion mistakes you should avoid.

You can go here to read all of the articles published during Roth Conversion Week.

Several "contributors" via social media also provided some excellent commentary regarding the power and complexities of Roth conversions. Below are the best thoughts from other financial advisors and thought leaders on the topic.

Separate Roth Conversions by investment. Keep the best and recharacterize (undo) the rest. You pick the winner! #RothConversionWeek
— John Nowak (@nowak_john) May 16, 2014

THINK THINK MT @nowak_john: Retired before Social Security benefits? Roth Conversion use 10-15% brackets before benefits #RothConversionWeek
— Yoenis Cespedes (@AppFlyer) May 16, 2014

Roth Conversion + charitable donation + appreciated stock? Offset conversion income with large multi-year stock gift. #RothConversionWeek
— John Nowak (@nowak_john) May 15, 2014

Post by Ed Slott and Company.

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The Top 10 Roth Conversion Mistakes

We end Roth Conversion Week with a list you never want to be on. Roth conversions are powerful, tax-free retirement vehicles if handled correctly, but if a mistake is made, you may owe a good portion of your hard-earned savings to taxes and penalties. Here's a list of the Top 10 Roth IRA (and conversion) mistakes you must avoid.

1. Making a contribution when you are not eligible - There are income limits for making a Roth IRA contribution. They are indexed for inflation and can be found in IRS Publication 590 or on our website at www.irahelp.com/2014. You also must have compensation (generally earned income) in order to make a Roth contribution.

2. Contributing more than the annual limit - In 2014, the most you can contribute to a Roth IRA is $5,500 (plus an extra $1,000 if you are age 50 or over during the year). Any amounts you contribute to a traditional IRA will reduce the amount you can contribute to a Roth IRA, dollar-for-dollar.

3. Funds being moved from an IRA to an IRA get put into a Roth IRA instead - This could be due to your own error, your advisor’s error or one made by your IRA custodian. Always follow up to make sure funds land in the right account. On the other hand, since this is technically just an accidental Roth IRA conversion, you can always recharacterize the money back to a traditional IRA by October 15 of the year following the year the mistake occurred - if you have discovered the error. Again, always follow up.

4. Doing a “back-door” Roth conversion and not using the pro-rata rule - When doing a Roth conversion that includes after-tax amounts, you must include the balances in all IRA accounts, not just the account being converted. The pro-rata formula can be found on IRS Form 8606, which must be filed with the account owner’s tax return.

5. Incorrect valuation of assets when doing a Roth conversion - Many tax scams are based on undervaluing assets. This is also true when it comes to Roth IRA conversions. A fair market value must be used for the asset converted. A common example is an annuity contract with riders. Such riders can increase the fair market value of the annuity contract, increasing the tax you will owe if you do a Roth conversion of the IRA annuity.

6. Shifting self-employment or business income into a Roth IRA to avoid income tax - This was a popular “strategy” for several years, which IRS has now made a listed transaction. It generally involves multiple entities and a self-directed Roth IRA. Eventually, earnings accrue to the Roth IRA and are never taxed as income - or at least that’s what a number of taxpayers thought before the IRS and the Tax Court hit them with, in some cases, millions of dollars in penalties and interest.

7. Doing a recharacterization and not reporting the conversion/recharacterization on the tax return - Sometimes people mistakenly believe that since a full recharacterization effectively cancels out a Roth conversion then nothing has to be reported on their tax return. That’s not true. Certain information, such as the gross distribution reported on a 1099-R by a traditional IRA custodian for the conversion, must be reported on your tax return no matter what.

8. Doing a conversion directly from an employer plan to a Roth IRA and not reporting the conversion on the tax return - This is generally an oversight. The 1099-R from the employer plan will have a Code G for a direct rollover to another plan. This is generally a non-taxable event, but not when the assets go to a Roth IRA. CPAs in the midst of tax season may overlook this unless you remember to tell them that your direct rollover was actually a Roth IRA conversion.

9. Beneficiaries of inherited Roth IRAs not taking RMDs - If you have your own Roth IRA account, there are no required distributions during your lifetime. When a non-spouse beneficiary inherits a Roth IRA, however, they do have required distributions beginning in the year after the account owner’s death. The Roth IRA custodian is under no obligation to tell the beneficiary about those distributions or to calculate them.

10. The biggest mistake of all? Not having a Roth IRA in the first place. You are never too old to do a conversion and you are never too young to start contributing to either a Roth IRA or an employer Roth account.

This article is part of Roth Conversion Week at The Slott Report. Come back all week long for insight and analysis on Roth conversions, the benefits of tax-free planning, the possible pitfalls involved and more. Click here to view all articles.

- By Beverly DeVeny and Jared Trexler

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Slott Report Mailbag: All About Roth IRA Conversions

This special edition of The Slott Report Mailbag answers several of the common Roth conversion questions we receive - from the beginning "conversion conversation" to the actual conversion process. As always, we stress the importance of working with a competent, educated financial advisor to keep your retirement nest egg safe and secure. Find one in your area at this link.

1.

How do I know if I can convert my employer plan funds to a Roth IRA?

Thanks for all that you do!

Seth

Answer:
All funds in traditional IRAs, SEP IRAs, and employer plans such as 401(k)s are eligible to be converted to a Roth IRA. Funds in a SIMPLE IRA can also be converted AFTER the SIMPLE account has been open for two years. A conversion before that date will be subject to a 25% penalty tax on the amount withdrawn AND the funds are not eligible for transfer to any other type of plan except another SIMPLE. To do a conversion of employer plan funds, you must be eligible to take a distribution from the plan.

2.

I just found out I was ineligible to make a Roth conversion. Is there anything I can do now to correct the error? I probably should have read a few articles here instead of just blindly trusting my financial advisor.

Joe

Answer:

Send questions to [email protected]

You might still have the Roth recharacterization option. The funds can be recharacterized to a traditional IRA up to October 15 of the year after either the year of the conversion or the year for which the contribution is made. You must notify both the Roth IRA and the traditional IRA custodians that you are doing a recharacterization. A net amount is recharacterized. Gains or losses on the account for the time the funds are in the account that are attributable to the contribution/conversion must also be recharacterized. The funds must be moved in a trustee-to-trustee transfer back to an IRA. Once this is done, the funds are treated as though they had always been in the IRA.

3.

My company plan has the option of converting my retirement plan funds to a Roth 401(k). My financial advisor has also talked about converting some or all of that money to a Roth IRA. Which one is better for my retirement?

Jane

Answer:
The "which one is better" question is a very individual question that can only be answered by you in tandem with your financial team. However, as part of Roth Conversion Week, Jeffrey Levine examined the advantages and disadvantages of converting funds to a Roth IRA or Roth 401(k). Click here to read the article. That should lay out a general plan which can be used to determine your best course.

This article is part of Roth Conversion Week at The Slott Report. Come back all week long for insight and analysis on Roth conversions, the benefits of tax-free planning, the possible pitfalls involved and more. Click here to view all articles.

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Where Should You Convert? Roth IRA or Roth 401(k)?

You’ve had "the conversion talk" and have decided that a Roth conversion is in your best interest. Now you have a choice ... should you convert your existing 401(k) money to a Roth 401(k) - your plan must have adopted this voluntary feature in order for you to do so - or should you make a conversion to a Roth IRA? While on the surface these two types of accounts are very similar - they both, for example, offer the prospects of tax-free growth and future distributions - there are a number of subtle, and not so subtle, differences that may make one type of conversion far more beneficial for you than the other. With that in mind, here is a summary of some of the most important factors to consider when making this decision:
 
Key Benefits of Converting to a Roth IRA

1. The Ability to Recharacterize - If you convert IRA funds to a Roth IRA and are unhappy with your conversion for any reason, you can recharacterize that conversion as late as October 15 of the year following the calendar year you converted. The word “recharacterize” is really just fancy tax-lingo for “undo.” Think of it as the tax version of the Ctrl+Z function on your computer. Should you end up recharacterizing your Roth IRA conversion, it’s treated as if the conversion never took place, eliminating the resulting tax bill. Common reasons to recharacterize a Roth IRA conversion include a drop in value of the account after converting, an inability to pay the resulting tax bill and simply a change of heart. If, on the other hand, you plan on converting plan assets to a Roth 401(k) or similar account (an in-plan conversion), you’d better double triple check and make sure you’ll have the money to pay the tax bill. There is no recharacterization option for in-plan conversions. Period. End of story. Once you take the leap, there’s no going back and the resulting tax bill is going to have to be paid one way or another. Owing money to any creditor is no fun, but outside of say, Tony Soprano, the IRS might be the worst creditor to have. Even going bankrupt won’t help you get out of that debt.
2. No RMDs - One of the biggest benefits of a Roth IRA is that there are no RMDs (required minimum distributions) during your lifetime. This allows your money to compound tax-free for as long as possible. In fact, the ability to eliminate RMDs is one of the most cited reasons people convert in the first place. Here’s the crazy thing, though. Only Roth IRAs have no RMDs. Roth 401(k)s and similar plan Roth accounts do! So if your Roth conversion is to a Roth 401(k) instead of a Roth IRA, you’ll generally still need to begin taking RMDs from that account when you turn 70 ½. If you’re still working at the time, you may be able to defer RMDs until December 31 of the year you retire. Of course, you can always get around this rule by transferring these amounts to a Roth IRA before that time, but if that’s the case, why not do the conversion to a Roth IRA in the first place and eliminate a step?

Other benefits of converting to a Roth IRA instead of a Roth 401(k)include:

• A common clock for all Roth IRAs for the 5-year qualified distribution rule
• Distributions are subject to ordering rules, allowing contributions and conversions to be distributed tax-free prior to any earnings (conversions may be subject to the 10% penalty).
• Generally a broader selection of investment options
• Funds may be accessed at any time whereas Roth 401(k) funds are still subject to the plan’s distribution rules
• IRA-only exceptions to the 10% early distribution penalty

Key Benefits of Converting to a Roth 401(k)

1. Federal Creditor Protection - Perhaps the biggest reason that a conversion at the plan level might make more sense for you than a Roth IRA conversion is when you have concerns about creditor protection. Creditor protection for IRAs, including Roth IRAs, is based on state law. In some states, like New York, that protection is very strong. In other states, however, there is reduced protection from creditors, or, in some cases, very little creditor protection at all. 401(k) plans, on the other hand, usually have very strong creditor protection provided to them at the federal level under ERISA (Employee Retirement Income Security Act). This protection shields assets in these plans regardless of where you live. While, to an extent, this protection may be advantageous for anyone, it is most commonly a key part of the Roth conversion decision for doctors, lawyers, contractors and other high-risk-of -being-sued professionals living in states with insufficient protection for IRAs.
2. Simplicity - Somehow, in today’s high-tech, high-efficiency, fast-paced world, there seems to be less time than ever before. With so much to do and so little time in which to do it, who needs to keep track of accounts all over the place? That, at least, is the attitude of many retirement savers today and, frankly, it’s hard to blame them. If you’re still working and have a 401(k) or similar plan, converting within the plan can help you keep all your retirement money in one spot and simplify your life. Of course, you should probably balance the advantage of simplicity against any disadvantages of doing the conversion in-plan rather than to a Roth IRA.

Other benefits of converting to a Roth 401(k) instead of doing a Roth IRA conversion include:

• The ability to take a loan from the funds
• The ability to purchase life insurance with the funds
• Plan-only exceptions to the early distribution penalty

This article is part of Roth Conversion Week at The Slott Report. Come back all week long for insight and analysis on Roth conversions, the benefits of tax-free planning, the possible pitfalls involved and more. Click here to view all articles.

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The BEST Way to Convert Your IRA to a Roth IRA

If you're thinking about converting some or all of your IRAs to a Roth IRA, there are two ways to do it. The two ways are by taking an IRA distribution or by direct transfer. Regardless of which method you choose, it will be treated and reported as a distribution from your IRA and a conversion deposit into your Roth IRA. IRA-to-Roth IRA conversions are taxable to you as ordinary income, but no 10% penalty applies, even if you’re under age 59 ½.

If you take a distribution from your IRA, you can complete the conversion by depositing the funds into a Roth IRA within 60 days after you receive the IRA distribution. When the check is made payable to you personally, you have control of that money, but the problem with completing a conversion this way is that the 60-day clock is ticking. This 60-day clock is the same clock that is ticking when you do an IRA-to-IRA rollover.

There are lots of times when things go wrong during those 60 days and the funds don’t get deposited on time into the Roth IRA. For example, you might use the money to pay some bills but then you lose track of time and don’t complete the conversion within 60 days. If that happens, you’re no longer eligible to do the Roth conversion. In that case, your IRA distribution will be taxable to you, plus you will owe the 10% early distribution penalty if you’re under age 59½. To make things worse, you won’t get the benefit of tax-free buildup of investment gains in the Roth IRA either.

The better way to do an IRA-to-Roth IRA conversion is by direct transfer. In a direct transfer, you don’t have control of the money because the funds are sent directly from your IRA to your Roth IRA. You can convert your IRA to a Roth IRA via direct transfer with the same custodian that has your IRA or to a different custodian. Either way, by using the direct transfer method there is no 60-day clock ticking so you eliminate the possibility that something will go wrong during that time frame.

Note: Whenever you’re doing an IRA-to-Roth IRA conversion, always tell the Roth IRA custodian that it’s a conversion to make sure that they properly report it as a conversion on IRS Form 5498.

This article is part of Roth Conversion Week at The Slott Report. Come back all week long for insight and analysis on Roth conversions, the benefits of tax-free planning, the possible pitfalls involved and more. Click here to view all articles this week.

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