Roth Conversion Pitfalls Explained
Roth Conversion Pitfall #1 and #2: Converting due to factors that aren’t relative marginal tax rate
A common myth: "If there’s a long time horizon or a high expected growth rate, Roth will be better than Traditional."
In reality, outside of a few minor and rare factors, the only input that matters is the marginal tax rate at contribution vs. withdrawal.
Example:
Marginal tax rate: 25% today and 25% in retirement
Growth: 10% per year for 35 years
➡️ $7,000 Traditional IRA contribution grows to $196,717. After paying 25% taxes at withdrawal equals $147,538.
➡️ $5,250 Roth IRA contribution (after paying 25% in taxes upfront) grows to $147,538 tax-free.
Bottom line: Pay taxes whenever your marginal tax rate is lower.
Here’s 3 caveats that can change the outcome even without a marginal tax rate change:
Paying Roth taxes with outside money which allows for a larger contribution to grow tax-free.
Required Minimum Distributions (RMDs) since Traditional IRAs force withdrawals; Roth IRAs do not.
State estate taxes — Traditional IRA assets can face double taxation if the estate exceeds state exemption limits.
Roth Conversion Pitfall #3, #4, #5 and #6: Waiting too long to start
Waiting too long to start Roth conversions might be problematic for a few reasons.
First, is missing an opportunity to pay taxes at a lower rate when having a low income year. Some prime opportunities for a Roth conversion are during a job loss or sabbatical, during a tough business year, or when retired and you’re living off of money from savings, a taxable brokerage account and/or a non-qualified annuity.
My example under Roth Conversion Pitfall #1 and #2 shows the decision to convert or contribute to Roth should hinge on marginal tax rates because the best answer is generally to pay taxes whenever your marginal rate is lower.
Second, is for Required Minimum Distributions (RMDs). Clients often ask if I can help reduce their upcoming tax bill that will be high because of their RMDs. The answer is yes, but we would have needed to start years ago. It’s usually too late to help when the RMDs are due. If your RMDs are going to provide a higher level of income than you want/need to spend or will bump you into a higher marginal tax rate, then you would likely benefit from Roth conversion planning in advance.
Lastly, you likely need to start (and complete) the 5 year clock to actually receive the tax benefit Roth money provides.
Please note that the rules to access Roth money differs for Roth contributions, the gains on Roth contributions, Roth Conversions and Rollovers from a 529 to a Roth IRA. There are also early access options for specific situations. So, withdraw carefully and maintain proper records!
Roth Conversion Pitfall #7: Not considering or fully understanding the IRA Aggregation Rule
If we aren't careful, the Aggregation Rule can create surprise taxes and even double taxation.
When you convert to a Roth IRA, the IRS doesn’t just look at the IRA you converted from. It looks at the balance of all your non-Roth IRAs at the end of the year to calculate the taxable portion.
This includes Traditional, Rollover, SIMPLE, and SEP IRAs — but excludes Inherited IRAs and a spouse's IRA.
Good news: If you’ve already completed a conversion without accounting for the Aggregation Rule, you may still have time to fix it. One option is to roll your Traditional IRA money into a 401(k), 403(b), TSP, or another qualified employer plan before year-end.
The situation only becomes complicated when there’s a mix of after-tax (non-deductible) and pre-tax contributions in your IRAs.
Example:
You contribute $7,000 after-tax to a Traditional IRA and convert it to a Roth IRA.
You also have a $1M pre-tax Rollover IRA balance at year-end.
The IRS aggregates these balances into a $1,007,000 total.
It calculates the after-tax pro-rata percentage: 0.69% ($7,000 ÷ $1,007,000).
Applying 0.69% to the $7,000 conversion means only $49 is treated as after-tax, and $6,951 is treated as pre-tax — and therefore taxable income.
Because of this, the $6,951 that you thought would be a tax-free Roth conversion instead becomes taxable — and its after-tax basis is magically transmuted into the Rollover IRA.
From here, we need to track this after-tax basis carefully to avoid paying taxes on it again in the future.
Roth Conversion Pitfalls #8 and #9: Avoiding the Step Transaction Doctrine
High-income earners often use the Backdoor Roth IRA strategy to bypass Roth contribution income limits. Moving too quickly or documenting the strategy improperly could raise red flags with the IRS. Here's what to be careful of:
The Two-Step Backdoor Roth Process:
Contribute to a Traditional IRA (no income limits for non-deductible contributions).
Convert the contribution to a Roth IRA.
While each step is legal, the IRS's Step Transaction Doctrine could treat these as a single transaction if executed too closely together, potentially violating Roth contribution rules. This could result in the contribution being taxed as an excess Roth contribution.
Pitfall #8: Moving Too Quickly Converting the Traditional IRA to a Roth the day after the contribution may signal intent to skirt income limits. The IRS hasn't explicitly applied the Step Transaction Doctrine to Backdoor Roth Contributions, but it may be worthwhile to follow the letter of the law. Best Practice: Wait at least 12 months between the contribution and conversion.
Pitfall #9: An Advisor's notes should avoid explicitly noting a "Backdoor Roth Contribution" strategy in CRM tools or client files. Precise language could be interpreted as intent to circumvent rules if audited. Instead, document the tax planning more generically.
Why 12 Months? While the IRS hasn't ruled directly on Backdoor Roths, a similar scenario offers guidance. In Revenue Procedure 2008-24, the IRS allowed a two-step annuity withdrawal strategy to avoid tax penalties if 12 months elapsed between steps. This precedent suggests a 12-month wait is a prudent approach for Backdoor Roth Contributions.
To stay compliant until the IRS provides explicit guidance, advisors and clients should:
Allow 12+ months between contribution and conversion.
Use general language in documentation.
By taking these precautions, you can help ensure the Backdoor Roth strategy remains a powerful tool for tax-efficient retirement planning.
Roth Conversion Pitfalls #10 and #11: Missing Mega Backdoor Roth Opportunities and Converting Multiple Tax Sources
To save beyond the classic retirement plan limits, many explore some creative strategies.
Before getting creative, we should usually simply maximize employer match, pay off high interest debt, build emergency savings, make HSA contributions if eligible, and max out the standard 401(k)/403(b)/TSP limits. Then, consider options like Mega Backdoor Roth contributions.
Unlike Backdoor Roth contributions, which may require a 12-month wait between the contribution and conversion to avoid the IRS Step Transaction doctrine (explained in my last post), Mega Backdoor contributions can be executed immediately.
Available in many employer plans, this strategy leverages the 2025 total contribution limit of $70,000 (plus catch-up), which includes employer, pre-tax, Roth, and after-tax contributions.
After accounting for employer contributions and the $23,500 standard limit, there’s an option to contribute after-tax dollars up to the $70,000 cap. Converting only these after-tax contributions to Roth—excluding pre-tax earnings & contributions—incurs no taxes, effectively swapping tax-deferred growth for tax-free Roth growth.
For tax efficiency, convert only after-tax contributions, avoiding pre-tax sources unless we want to pay taxes on them too, which is rarely optimal.
Roth Conversion Pitfall #12 - Converting all at Once
In some cases, performing a Roth conversion in a single lump sum is reasonable. For instance, Roth conversion benefits may not be recognized until year end, or the portfolio value may have declined, allowing more shares to be converted at the same tax cost.
When investing a large sum of money, many choose to spread out investments over time breaking the amount into smaller, regular investments to avoid buying at a market peak. This approach can also be applied to Roth conversions, allowing you to convert in smaller, regular increments instead of a lump sum.
However, a key drawback is that the market rises about 60-70% of the time, so converting gradually often means converting fewer shares as prices rise. If you’re comfortable with market fluctuations, converting or investing a lump sum upfront may be more advantageous by obtaining more time in the market.
A barbell strategy provides both extra time in the market and the precision of a year end conversion. Typically, you have an idea of how much to convert at the start of the year, though the exact amount becomes clear later when income and deductions are finalized. Simply convert the majority of the planned amount early in the year and a fine tuned amount toward year end once the optimal, total conversion amount is determined.
Roth Conversion Pitfall #13: Banking on a recharacterization option
Roth conversions used to offer a win-win scenario. If the market rose after converting pre-tax dollars to a Roth, you benefited from tax-free growth instead of tax-deferred growth. If the market dropped, you could reverse the conversion through a recharacterization, avoiding taxes on what's a now smaller amount.
That flexibility ended with the Tax Cuts and Jobs Act of 2017. Recharacterizations of Roth conversions are no longer allowed. Once a conversion is completed, it’s locked in—regardless of what happens next in the market.
Roth Conversion Pitfall #14: Missing the little things
Increasing income, even just a little, may cause unexpected costs outside of just having a larger tax bill.
First, and most obvious, is moving into a higher federal tax bracket. (Most Roth conversion amounts are calculated to maximize the current tax bracket to avoid moving into a higher one).
Other items include the percentage of SS that is taxable, your medicare premiums by moving into a higher IRMAA bracket, affordable care act subsidies, state tax brackets, Alternative Minimum Tax, Net Investment Income Tax, capital gains tax brackets, tax credit phaseouts and more.
So, let’s consider the holistic financial situation when making Roth conversions so that we can achieve the best outcomes.
Roth Conversion Pitfall #15: Converting in a high income year
Pay taxes when the relative, marginal tax rate is the lowest. *See the example under Pitfall’s #1 and #2 to see why the math proves this is just about the only factor that matters.
Converting during a high income year increases the chances of paying more in taxes overall and we’d likely be better off leaving the Traditional (Pre-tax) assets as is. If the marginal tax rate is lower when making the conversion, then it's more likely that the conversion will be worthwhile.
Roth Conversion Pitfall #16: Paying taxes from the account
When converting a Pretax retirement account to a Roth account, pay the taxes out of pocket from a checking, savings, or brokerage account, rather than using funds from the retirement account itself.
Reasons to pay taxes out of pocket:
Maximize the Roth conversion amount. Withholding taxes from the account reduces the amount converted to Roth, resulting in less tax-free growth potential.
Enhance overall tax efficiency. Generally, pretax funds growing tax-deferred in a retirement account are more advantageous than funds in a taxable account like checking, savings, or brokerage.
Avoid potential early withdrawal penalties. Withdrawing funds to cover taxes may trigger penalties, depending on your age.
Simplify tax filing. Paying taxes from an outside source streamlines the tax reporting process.
Two scenarios where paying taxes from the account may make sense:
During low-tax years, when the tax impact is minimized.
When you’re able to avoid early withdrawal penalties and lack sufficient taxable funds to cover the taxes.
Remember, the decision between Roth and pretax accounts hinges almost entirely on the tax rate at the time of contribution versus the time of withdrawal. Paying taxes out of pocket when converting to Roth improves overall efficiency and is one of the few ways to tilt outcomes in favor of Roth.
Roth Conversion Pitfall #17: Losing Creditor Protection
Anytime funds move out of an employer sponsored plan (401k, 403b, TSP, 457’s, etc.) and into an IRA, there’s a risk of losing creditor protection.
IRA’s can still offer creditor protection equal to that of an employer sponsored plan but the rules are more complicated because they depend on your state of residence, the type of IRA, how the money moves into the IRA and a couple more complications.
If creditor protection is important to you, work with a qualified professional who understands these complexities, or if possible, complete your conversion within your employer sponsored plan.
Thanks for reading! Feel free to email any questions or comments to Peter@ShammasFP.com.
