Another Roth Question

[kjpliny]

I've been reading about Roth conversions and am trying to figure out if waiting for a window during the transition from working to retiring early is the best time to convert a standard IRA to a Roth. In my case, my wife will receive a generous DB pension when she turns 55, but if we decide to retire early a few years before she can begin collecting her pension, we will have basically zero income and would be living off of post-tax account withdrawals until the pension kicks in.

If you took advantage of this period of zero income, you could theoretically convert substantial amounts (up to the 15% income upper bracket) of regular IRA money to a Roth and still stay in the 15% tax bracket. Am I missing something here? It's probably better if she remained working until full retirement age as the pension would increase and this would offset any gains of converting to a Roth, but then again, she'd be working longer. I wonder if there's an easy way to compare scenarios to see what would be better. I like having a huge sum in a Roth later on because you never know what the tax rates will be like in another 20 or 30 years. Her pension alone will most likely put us into the 25% tax bracket, so once we retire, any withdrawals from regular IRAs would be at a high tax rate.

 

[REWahoo]

If you took advantage of this period of zero income, you could theoretically convert substantial amounts (up to the 15% income upper bracket) of regular IRA money to a Roth and still stay in the 15% tax bracket. Am I missing something here?

Although we're lacking your complication of pension income , this is what I'm in the process of doing. You will see some concerns about the possibility of changes in the tax laws which could cause your ROTH to be taxed twice, but I'm of the opinion the risk of that is reasonably small. And since it's clear to me my future marginal tax rate on withdrawals of IRA money will be in the 25% or greater range, I'm going to pay my 15% now and not worry too much about it.

 

[mikemctx]

We're doing exactly the same to fill up our 15% tax bracket. Even consdering whether it's worth going into the 25% tax bracket a little and converting more.

 

[JohnEyles]

In my state, the first $2K of IRA distribution is state-tax free. This is
another angle on the conversion calculation. I simply figure I should
convert a minimum of $2K per year, regardless of what my federal bracket
is. I'm not sure for how many states this is the case, but it's worth checking.

 

[ERD50]

We're doing exactly the same to fill up our 15% tax bracket. Even consdering whether it's worth going into the 25% tax bracket a little and converting more.

I have been considering that also. Can't predict the future, but I'd still say the odds are that tax rates will not be moving lower. If you know that you will be in what is now a 25% bracket, it might be a good hedge against the increases.

Currently, I lose much of the $2000 tuition credit ( one kid in college) if I convert even to the top of the 15% bracket, so the combined hit does not seem worth it to me, in my particular situation.

-ERD50

 

[mh]

If the money is going to stay unspent for any long period of time
isn't it almost always better to roth convert it ?

Isn't the issue at hand at least as much about how long the money will stay in the acct.
before it becomes income?

e.g., if it stays untouched for ten years in the regular IRA you've
probably got at least double whatever the min tax rate ends up being
in 10 years vs whatever hit you take taxing it now.

Or am i missing something ?

 

[ERD50]

Or am i missing something ?

You seem to be missing the fact that you pay the taxes when you convert - so that money is gone and does not grow. And, it would grow in a Trad Roth also.

When I did a spreadsheet on this, if the tax rate is the same over time, a conversion is a wash. Makes no diff if you pay the taxes from the Roth (convert less than the full amount), or pay the taxes outside the Roth (you 'lose' that money and you lose it's growth).

So, for this to be advantagous, the future marginal tx rates need to be lower - if equal, no impact, if lower, it is a 'mistake'.

-ERD50

 

[mh]

You seem to be missing the fact that you pay the taxes when you convert - so that money is gone and does not grow. And, it would grow in a Trad Roth also.

When I did a spreadsheet on this, if the tax rate is the same over time, a conversion is a wash. Makes no diff if you pay the taxes from the Roth (convert less than the full amount), or pay the taxes outside the Roth (you 'lose' that money and you lose it's growth).

So, for this to be advantagous, the future marginal tx rates need to be lower - if equal, no impact, if lower, it is a 'mistake'.

-ERD50

Sorry i meant convert from regular IRA to roth. Or did you already get my original meaning ?

 

[ERD50]

Sorry i meant convert from regular IRA to roth. Or did you already get my original meaning ?

Yes, when you convert from a 'regular' (traditional) IRA to a Roth IRA, the (edit:contribution) amount converted is taxed as income.

But, you normally pay no taxes when you withdraw from the Roth.

Time has nothing to do with it (other than tax rates may possibly change over time). If tax rates are the same, it is a wash whether you convert (from Trad to Roth) and hold for 10 years, or convert and hold for 40 years, or don't convert.

-ERD50

 

[Peter]

One other factor to consider is that capital gains inside a traditional IRA will be taxed as regular income when they are withdrawn. Roth withdrawals are, of course, tax free. So even if tax rates remained the same, there could be an advantage in doing the conversion, if some or all of the assets are likely to show significant capital gains.

Peter

 

[d]

Makes no diff if you pay the taxes from the Roth (convert less than the full amount), or pay the taxes outside the Roth (you 'lose' that money and you lose it's growth).

... not quite. while true that it's a wash if tax rates remain the same, if you pay the taxes with "outside" $ you will have effectively increased the amount in your IRA.

 

[ERD50]

Quote
Makes no diff if you pay the taxes from the Roth (convert less than the full amount), or pay the taxes outside the Roth (you 'lose' that money and you lose it's growth).

... not quite. while true that it's a wash if tax rates remain the same, if you pay the taxes with "outside" $ you will have effectively increased the amount in your IRA.

Yes, the amount in the Roth is different of course. But, looking at the 'whole pile' - if tax rates are the same at the time of conversion and at the time of withdraw, the total amount of money in your pocket will be the same, no matter what.

-ERD50

 

[d]

the total amount of money in your pocket will be the same

at that point in time. but further down the road, the pile will be bigger if more (rather than less) is in the roth.

 

[ERD50]

Quote
Makes no diff if you pay the taxes from the Roth (convert less than the full amount), or pay the taxes outside the Roth (you 'lose' that money and you lose it's growth).

... not quite. while true that it's a wash if tax rates remain the same, if you pay the taxes with "outside" $ you will have effectively increased the amount in your IRA.

at that point in time. but further down the road, the pile will be bigger if more (rather than less) is in the roth.

Sure. But with more in the Roth you need to account for all the 'lost' principle and gain when you paid the taxes with 'outside' $. If you assume the same return, it will be a wash. I guess you could say the return is less on the outside money as it gets no tax advantage - but then that depends on cap gains distributions, etc.

Bottom line (I think?), is that it is a better apples-to-apples comparison to pay the taxes from 'outside' the IRA. You are basically paying back the tax break you got when you made the Trad contribution.

-ERD50

 

[d]

you could say the return is less on the outside money as it gets no tax advantage

exactly!

 

[mh]

One other factor to consider is that capital gains inside a traditional IRA will be taxed as regular income when they are withdrawn. Roth withdrawals are, of course, tax free. So even if tax rates remained the same, there could be an advantage in doing the conversion, if some or all of the assets are likely to show significant capital gains.

Peter

That's what i was fumbling for when asking my question before. The reason i asked is
that i'm expecting to have my convential IRA chunk of money be sitting around
for 15-20 years. one would hope it would accumulate significant capital
gains during that time. so i should roth convert it when it's moderately reasonable
to do so..

 

[Nords]

Time has nothing to do with it (other than tax rates may possibly change over time). If tax rates are the same, it is a wash whether you convert (from Trad to Roth) and hold for 10 years, or convert and hold for 40 years, or don't convert.

I think a Roth conversion is too complex a multi-variable problem to be treated with phrases like "time has nothing to do with it" and "it's a wash".

If the conversion taxes are paid from funds outside of the conventional IRA, then the amount of the tax paid is effectively an additional contribution to the Roth which will compound as long as it's untouched. The tax-free compounding difference between 10 years and 40 years is significant. In our cases we're shifting a portion of our assets from taxable accounts to Roths and so we're no longer paying taxes on their gains.

While tax rates are one component of a conversion, there's the possibility (probability?) of having to take a big-enough RMD to raise your income to a higher tax bracket and also resulting in taxes on Social Security distributions. So although the U.S. tax code numbers may be the same, the effect on one's personal income tax can be pretty punitive...

 

[chinaco]

Has anyone identified any good papers on Roth IRA strategies? I am interested in learning more about conversions from Trad IRA and 401ks to Roth with an eye on reduced taxes.

 

[Jeb-NY]

[quote
While tax rates are one component of a conversion, there's the possibility (probability?) of having to take a big-enough RMD to raise your income to a higher tax bracket and also resulting in taxes on Social Security distributions. So although the U.S. tax code numbers may be the same, the effect on one's personal income tax can be pretty punitive...
[/quote]

Ding DIng Ding Ding

That's why I plan to do some conversions to the top of th e 15% bracket starting this year.

Jeb

 

[Nords]

Has anyone identified any good papers on Roth IRA strategies? I am interested in learning more about conversions from Trad IRA and 401ks to Roth with an eye on reduced taxes.

Ed Slott's written a book about it, Fairmark.com has an article and a calculator that includes the effect of a conversion on SS taxes, and there are probably two or three dozen threads on this board that can be found by searching for the words "Roth IRA" and "conversion"...

 

[ERD50]

I think a Roth conversion is too complex a multi-variable problem to be treated with phrases like "time has nothing to do with it" and "it's a wash".

Nords, that is true, my simple spreadsheet was not accounting for the tax you would be paying on the growth of the money that would be used to pay the taxes on the conversion (an opportunity cost). So, taking that into account, there is less lost opportunity to subtract from the final Roth total, so it makes the Roth look a bit better when you convert the full amount and pay the taxees outside that account.

- however...

At 15% tax rates, this is really small. For simplicity, I assumed the gains on the money outside the account would be taxed at the same 15%, all at the end (no distribution/dividends). After 30 years, the Roth looks 2.19% better; 0.072% as an annual rate. If those cap gains got a favorable treatment at the 15% marginal tax rate, or there were taxes to be paid along the way, it would look a bit better.

So no, looking at it with the taxes paid outside the conversion it is not a wash, but it is really close. The real benefit is a hedge against future higher marginal tax rates.

Bottom line (IMO) convert to Roth, as long as you feel reasonably certain that your future tax rates will be higher than the rate at which you convert. If they are the same, nothing lost, maybe a little gained if you pay the taxes outside the account.

-ERD50

 

[FIRE'd@51]

One other factor to consider is that capital gains inside a traditional IRA will be taxed as regular income when they are withdrawn. Roth withdrawals are, of course, tax free. So even if tax rates remained the same, there could be an advantage in doing the conversion, if some or all of the assets are likely to show significant capital gains.

This is incorrect with regard to a conversion. It is true for a Roth contribution. Once inside either IRA the money compounds tax-free. As ERD50 has pointed out, the laws of multiplication are commutative, i.e. A x B = B x A

Let

P = the current amount in your traditional IRA

t = tax rate (assumed constant)

R = rate of return on IRA investments (the same in Traditional or Roth)

N = number of years

Case 1 - Leave money in traditional IRA and pay taxes upon withdrawal

Money after tax at withdrawal = P x (1+R)^N x (1-t)

Case 2 - Convert to Roth

Money after tax at withdrawal = [P x (1-t)] x (1+R)^N = same as Case 1

The real problem, as Nords points out, comes with the RMD's associated with the Traditional IRA and how they interact with your other income

 

[yakers]

Bottom line (IMO) convert to Roth, as long as you feel reasonably certain that your future tax rates will be higher than the rate at which you convert. If they are the same, nothing lost, maybe a little gained if you pay the taxes outside the account.

-ERD50

One other point I consider is it is good to tax diversify; have taxable, tax deferred and tax free funds so I can draw from whatever source works best at the time both tax wise and also from an estate planning point of view.

 

[ERD50]

One other point I consider is it is good to tax diversify; have taxable, tax deferred and tax free funds so I can draw from whatever source works best at the time both tax wise and also from an estate planning point of view.

yakers, that is a good point also - that flexibility might help us in the future if we could benefit by lowering our taxable income in one year vs another.

FIRED'@51 did the math, I'll do an example for the math-o-phobics. When you do a Roth conversion and pay the taxes from the converted amount, time really does have nothing to do with it, it *is* a wash.

Example:

Assume same tax rate at start and end; 25% in this case - could be anything. I used a growth of 10x, could be anything.

A) $10,000 in Trad IRA. Grows 10 times to $100,000 over time. 25% to taxes, you have $75,000 in your pocket.

B) $10,000 converted from Trad IRA to Roth. 25% goes to taxes leaving $7,500 in Roth. Grows 10 times to $75,000 over the same time period. Zero to taxes, you have $75,000 in your pocket.

As stated above, paying the taxes outside and getting the full $10,000 into the Roth has advantages. Slightly higher return overall, and more flexibility with more in the Roth. That is what I am doing.

-ERD50

 

[teejayevans]

B) $10,000 converted from Trad IRA to Roth. 25% goes to taxes leaving $7,500 in Roth. Grows 10 times to $75,000 over the same time period. Zero to taxes

IIRC, its generally recommended to pay the taxes from funds outside the IRA, there by
maximizing you growth of tax-free money.

As previously stated, and I agree 110%, forgetting the math, it's best to be tax diverse.
Tom