401k's, IRA's and RMD's - tax consequences

[BuysToys]

The i-Orp developer participated in a discussion on these boards about tax optimization and Roth conversions. Here is the thread: http://www.early-retirement.org/forums/f28/do-you-use-i-orp-68144-4.html.

While I agree with the developer's assertion that going into a higher tax bracket for a short number of years can be offset by the tax free earnings gained by early Roth conversions, ACA has added a wrinkle to my personal plan. Right now (subject to change, of course) I plan to do a Roth conversion in 2015 up to the 400% FPL cliff and we will start taking distributions from DH's IRA in 2016 when he hits 59.5. There will be a small window still left to fill up to the 400% FPL, so I will continue to do small conversions until he is on Medicare. I have no concrete plan after that as there are too many unknown variables.

[Ronstar]

I agree Midpack - I would pay for a "plan" to maximize the tax efficiency of these withdrawals. Still searching for a calculator that can incorporate ss income into the mix and spit out what should be withdrawn and when. In the mean time I'm going to start moving some 401k holdings to bonds and taxable holdings more to equities to capture the capital gains treatment in lieu of ordinary income tax on the equity gains.

[ChicagoGal]

Quote:

Originally Posted by gauss I believe that (I-Orp) Retirement Calculator - Parameter Form takes a shot at optimizing your Roth conversions to maximize your overall retirement spending plan.

That's what I'm using as a starting point as well. Then taking those general buckets and seeing if I can apply it to the specific accounts I have to make sure I understand (and agree with) it.

[gauss]

Quote:

Originally Posted by Midpack +1. Same conclusion I've come to, though I'd rather see the (theoretical) math at least. Filling out to 15% between now and age 70 won't be enough to minimize lifetime taxes as RMDs and Soc Sec alone will probably exceed our spending after age 70 for us (nice problem I know). So I plan to keep taxable as constant (inflation adjusted) as possible using dividends, passive and active cap gains, RMDs, Soc Sec and whatever other "income events" we expect. Still wish there was a calculator or even a pro who could do it (one of the few financial services I'd pay for).

Have you run I-ORP calculator yet?

If not, I think it may answer most of your questions.

It give a year by year breakdown of all the cashflows including the Roth wd's and conversions. You can manually backout how far into the 25% bracket you go each year or set inflation to '0' and all other rates to 'real rates' manually to give a clearer view of the analysis.

For my case, it was fairly easy to fill out their parameter sheet and insightful as a baseline.

-gauss

[Ronstar]

Thanks Gauss and BuysToys - I'll give I-Orp a try.

[Midpack]

I agree that I-ORP is helpful, but it's a tax impact axe vs scalpel by their own admission in this post http://www.early-retirement.org/foru...ml#post1449169. I'd be more comfortable seeing more detailed results and what tax code assumptions they're using - a 'black box' doesn't provide enough reassurance for me. However, I realize it's not easy after trying to develop a spreadsheet of my own...that's why I'd be willing to pay a pro, I know how difficult an exercise it is. I found a Boglehead that developed a spreadsheet, but it was very hard to understand, IMO you'd have to be the author to trust it. Sigh...the search continues.

[kaneohe]

Quote:

Originally Posted by Car-Guy Well, I like one of the ideas and I'm not going back to work.

......and if you do implement that idea, she will probably still be working and can provide the compensation for your spousal IRA , hopefully deductible, which might provide more room for the conversion.

[jim584672]

Every time I try to figure out Roth conversions, tax brackets, RMDs, Obamacare effects - I get a headache and give up.

[kaneohe]

Quote:

Originally Posted by Ronstar I always heard that one should have their bonds in tax advantaged accounts and have equities in taxable accounts. I never drilled down to get the reasoning of this. But given that some of the gains in the taxable accounts are taxed as capital gains, and all distributions from IRA's/401k's are taxed as ordinary income - it makes sense to put all bonds in 401k/ira and equities in taxable accounts. Here's a few answers from experts on nerd wallet.com. 2 interesting ways to postpone RMD's are marrying a much younger spouse, or keep working past 70.5. How do I reduce my required minimum distributions (RMDs)?

Also from the link or implied there: (or from the 1040 listing of income)
in order to free up the 15% bracket for conversions:
1)put ordinary income generators (bonds except for muni , and CDs) in tax-deferred accounts
2)put equity in taxable....and make it passive index tax-efficient equity to rduce CG distributions..both LT/ST
3)Delay pensions if possible
4)Delay SS if possible

[GrayHare]

Maintaining some level of taxable income can be wise: since some deductible expenses are almost inevitable eventually (such as medical) for tax efficiency you want enough taxable income to deduct them against, otherwise those deductions expire worthless.

[kaneohe]

Can't you deduct those expenses against the conversion income that you are using to fill the 15% bracket?

[kaneohe]

Quote:

Originally Posted by kaneohe Can't you deduct those expenses against the conversion income that you are using to fill the 15% bracket?

Perhaps you meant that you can overdo the conversions if that leaves you
w/o taxable income and diversity in income sources is useful.

[PatrickA5]

Quote:

Originally Posted by purplesky So just out of curiosity does anybody know the rough dollar amount saved in a tax deferred 401k/IRA that pushes people into this RMD withdrawal tax issue. I have a pension also and a pension really presents a problem for RMD and keeping tax bracket low. I am starting to think that I am saving too much in my tax deferred 401k. Is there an actual ballpark dollar amount that could be considered a stop point in a tax deferred 401k/IRA. say 1 million. 3 million.

Having a pension, and to a lesser extent, Social Security makes it really hard to manipulate the numbers between tax deferred, taxable and tax free income to a point where it's easy to stay within the 15% bracket once RMDs start.

If you file MFJ, you basically have $20,300 of tax free income due to the standard deduction and the 2 exemptions. This income should probably come from the tax deferred bucket (401K, etc). Based on a 3.65% RMD factor for the first year, you can have around $550K in 401ks and Traditional IRAs that would produce that $20,300 of income that will be tax free. You could add all of the Roth distributions you want on top of those RMDs and you'd still pay zero taxes. Adding in Social Security will muddy up the waters to some extent and you'd end up having some of your SS taxable. You can play with the numbers to try and achieve zero taxes, or more likely, you can play with the numbers to try and stay in the 15% tax bracket (which would also make your qualified dividends and LTCG tax free). One of the best ways to do these "what ifs" calculations is to buy TurboTax and learn how to use it.

If you have a large fully taxable pension, then just assume you'll always be paying taxes forever.

[GrayHare]

Quote:

Originally Posted by kaneohe Perhaps you meant that you can overdo the conversions if that leaves you w/o taxable income and diversity in income sources is useful.

Exactly, it's possible to over-convert to Roth, but that largely depends on individual circumstances.

[LOL!]

Taking withdrawals from a 401(k) or traditional IRA has the same tax consequences as converting that money to a Roth IRA and also reduces future RMDs. Thus, I don't see any problems with converting which should be the default mode.

At age 70.5, if current laws do not change, one can make a QCD which covers their RMD. One may say, "But I need that money to pay expenses?" That's where all those previous Roth IRA conversions help you. Don't forget that you are allowed to withdraw from a Roth and not pay taxes on those withdrawals.

And later on in life when you are paying medical expenses in your nursing home bed, all those RMDs will be tax-free anyways because of your itemized deductions.

For those that use i-orp.com, but sure to run a real tax program such as TurboTax on the scenarios that it gives you. One may be surprised that one may be able to make larger conversions with lower taxes because of one's personal tax situation.

Finally, one doesn't use sequential withdrawals (all taxable first, all tax-deferred next, all Roth last), but one makes withdrawals from a mixture of account types in order to have the lowest taxes.

[davismills]

Quote:

Originally Posted by Car-Guy Well, I like one of the ideas and I'm not going back to work.

That's rich. Just spit out my evening cocktail. Marry too young and you'll have to go back to work.

[MBAustin]

I'm in the "it gives me a headache" camp like jim.

Basically, I've concluded that we benefited in our high-earning years (two good jobs plus decent bonuses) by being able to defer enough income to keep in a lower tax bracket, and the result is we pay taxes later. As much as it is annoying when it comes time to write the check, I'm convinced we are still better off.

[GTFan]

Quote:

Originally Posted by LOL! Taking withdrawals from a 401(k) or traditional IRA has the same tax consequences as converting that money to a Roth IRA and also reduces future RMDs. Thus, I don't see any problems with converting which should be the default mode.

If you're willing to ignore or are not able to gain the significant ACA subsidies for staying under 250% FPL, sure. The ACA throws yet another variable into the Roth conversion mix for those that don't have significant pension income.

My plan is simple, at this point - keep income low to maximize subsidies and ignore Roth conversions, knowing that I don't want to leave a huge chunk of money to my children. I'd much rather contribute excess RMDs to charities, which will also (with itemized deductions) greatly reduce Uncle's share. And I have about half of my port in taxable investments which means I can control income very nicely, at least until I have to start tapping tax-deferred stuff.

[ejman]

Since I have no pensions my strategy pre RMD has been to derive my living expenses from my taxable funds invested primarily in bond funds and high dividend balanced funds. My IRA's are in stock funds I also started SS at 62 so as to limit total income when RMD's start and in anticipation of taxing SS at 100%.

As RMD's start in 6 years I plan to convert all my taxable holdings to an index stock fund (S&P 500 or total stock Market Fund) the year before so as to limit dividend and CG distributions. Conversely, mi IRA's will be switched to Bond and balanced funds. Most of my income then will come from RMD's and I expect that if present tax rates hold my top fed tax rate will be 15% unless my IRA stock funds go up in value tremendously ( which would be a nice problem to have).

I will not be converting to Roth's for a couple of reasons:

With my psychological make up whatever I convert to Roth will never be coming out because I'd rather cut living expenses. So effectively I'd be paying taxes on money I will not use.

I just do not know what curves future tax laws will throw at Roth's either directly or in tangential ways.

My strategy of converting all my taxable funds to Index stock funds will result in a stepped up value upon my demise for my heirs since I intend not to touch Taxable funds once RMD's start.

I realize this strategy is exactly the opposite of what is generally recommended...

[karluk]

Quote:

Originally Posted by BuysToys While I agree with the developer's assertion that going into a higher tax bracket for a short number of years can be offset by the tax free earnings gained by early Roth conversions, ACA has added a wrinkle to my personal plan.

I am coming to the conclusion that contributing to a donor advised fund is a partial solution to this dilemma, for me at least. I-ORP correctly recognizes that part of the key to minimizing RMDs is to get as much money out of the tax sheltered account as soon as possible. If I take a large distribution next year and then contribute it to a donor advised fund, I get a charitable deduction that would eliminate the additional taxes owed on the distribution.

We are in the situation that the standard deduction is more than our itemized deductions, so we can only itemize every other year by paying two years of property taxes in the same calendar year. 2015 is a year that we will itemize, so I will look into setting up a donor advised fund then.

So the tentative plan for 2015 is to make Roth conversions up to the limit of the 15% tax bracket and then open a donor advised fund with additional withdrawals that would normally push us into the 25% bracket. It seems to me that this strategy is likely to be just as effective as I-ORP's front loaded Roth conversions, but without incurring the large tax hit that the Roth conversions would entail.