(Dow Jones) While most of the four in 10 U.S. households who own an IRA don't plan to convert those accounts to Roth IRAs this year, tens of thousands, perhaps even hundreds of thousands, are deciding to take the conversion step, and many are making some astonishing mistakes that experts say could be avoided easily.
What are those mistakes and what can you do to avoid them?
Paying Tax Unnecessarily
More than a few investors have made after-tax (nondeductible) contributions to their IRAs or qualified employer plans over the years. With deductible contributions, you avoid paying taxes on the contribution amount until distribution at a later date. With after-tax contributions you include the contribution amount as part of your taxable income in the year contributed, but then get to withdraw the contribution amount (basis) tax-free at a later date.
When taxpayers who have made after-tax contributions decide to convert savings from a regular IRA or employer-sponsored plan to a Roth IRA, the investor is generally able to avoid taxes on the portion of the conversion that represents after-tax basis. But that's not what IRA owners and their advisors are doing, according to Ben Norquist, president and CEO of Convergent Retirement Plan Solutions.
"We continue to see individuals with after-tax basis and their advisors who fail to take advantage of the various strategies available for doing a Roth IRA conversion at the lowest cost," Norquist said. "By not being aware of the options available to them, many individuals continue to incur a larger-than-necessary tax hit when doing conversions where after-tax basis amounts are involved."
It's Not All-Or-Nothing
Another mistake: IRA owners look at Roth IRA conversions as an all-or-nothing proposition.
"While 100% conversion may make sense for a small minority of individuals, we continue to believe that the majority of investors would be best served by considering a partial conversion as a means of diversifying their overall tax risk," Norquist said.
In fact, he said, two things need to occur within the financial services industry for the Roth alternative to be used in a rational manner: 1) The industry needs to get a better handle on the real math behind the conversion decision and quit reinforcing overly simplistic rules of thumb such as, "You should only convert if you anticipate being in a higher tax bracket in retirement." And 2) the industry needs to get away from thinking of the Roth conversion option as an all-or-nothing decision and begin focusing on partial Roth IRA conversions as a legitimate tax-hedging strategy.