Converting t-IRA dollars into Roth IRA dollars

[vtd0918]

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[Accidental Retiree]

Quote:

Originally Posted by Scuba Why is this? Either way, funds are coming out of your portfolio to pay the taxes so what difference does it make?

If you convert $10,000 and owe $2,000 in taxes, paid from the converted funds, you end up with $8,000 in your new Roth.

If you pay taxes with external funds, you end up with the entire $10,000 in your Roth.

We prefer to direct the whole amount to the Roth, so we pay with external funds.

[pb4uski]

Quote:

Originally Posted by Scuba Why is this? Either way, funds are coming out of your portfolio to pay the taxes so what difference does it make?

Here's the difference based on converting $100 and incur a 20% tax.

If you pay the tax from taxable funds, you then have $100 invested that will generate tax free income for the rest of your life.

If you pay the tax from the conversion, you only have $80 that will generate tax free income for the rest of your life and $20 that will generate taxable income for the rest of your life.

The difference is the taxes on future earnings of the $20 of taxable funds that are retained.

If you convert $100 and pay the $20 in tax from taxable funds and earn 7% per year in 30 years you'll have $761 in your Roth. If you pay the tax from the proceeds, you'll only have $686 ($609 in the Roth and the $20 will have grown to $77).

[bingybear]

Quote:

Originally Posted by Accidental Retiree If you convert $10,000 and owe $2,000 in taxes, paid from the converted funds, you end up with $8,000 in your new Roth. If you pay taxes with external funds, you end up with the entire $10,000 in your Roth.

The example looks incomplete. In the first one "convert $10,000 and owe 2,000 in taxes paid with the conversion, you end up with $8k conversion NOTE - this cost 10k
In your second case you end up with a conversion of 10k but a cost of 12k

If you look at 10k conversions

using after tax $

10k from IRA is converted to roth. Using 20% taxes as above example we will pay taxes using after tax $ is $2k
so our cost is $10k+$2k=$12k

If we use all IRA money for the conversion
$10k for conversion
$ 2K for the conversion tax
$ 400 for tax on the $2k tax
$ 80 for tax on the $400
$ 16 tax on the 80
and so on
_________________
approx $12500

So pulling all the $ from the IRA costs about $500 more

[Sunset]

Where you pay the tax on conversion from is often thought of when a person has employment income or savings just lying around.

If you have a pile of after tax $$ lying around then paying the tax for a conversion with the after tax $$ is best.

However if you have no after tax money from a job for instance, and need to withdraw say $10,000 from an IRA to meet living expenses, then if you do a conversion on top of that, you will need to withdraw more from the IRA for the taxes or pay it out of the conversion funds.

[bingybear]

Quote:

Originally Posted by Sunset Where you pay the tax on conversion from is often thought of when a person has employment income or savings just lying around. If you have a pile of after tax $$ lying around then paying the tax for a conversion with the after tax $$ is best. However if you have no after tax money from a job for instance, and need to withdraw say $10,000 from an IRA to meet living expenses, then if you do a conversion on top of that, you will need to withdraw more from the IRA for the taxes or pay it out of the conversion funds.

Many of posted that Roth conversion aren't worth it if you have to pull the tax out of the IRA. I've never run the numbers to convince myself. I'm not sure people have after tax money just lying around anymore than IRA money just lying around. I would think it would be invested for the most part. But the point that some have more after tax $ is understood.

[pb4uski]

I wouldn't say that is isn't worth doing Roth conversions if you pay the tax from the proceeds, more that it is better if you pay the tax from taxable accounts since you then get to have more money invested tax-free... that's all. See post #63 for details.

[43210]

Quote:

Originally Posted by pb4uski Here's the difference based on converting $100 and incur a 20% tax. If you pay the tax from taxable funds, you then have $100 invested that will generate tax free income for the rest of your life. If you pay the tax from the conversion, you only have $80 that will generate tax free income for the rest of your life and $20 that will generate taxable income for the rest of your life. The difference is the taxes on future earnings of the $20 of taxable funds that are retained. If you convert $100 and pay the $20 in tax from taxable funds and earn 7% per year in 30 years you'll have $761 in your Roth. If you pay the tax from the proceeds, you'll only have $686 ($609 in the Roth and the $20 will have grown to $77).

In addition, if 10% early withdrawal penalty is applicable, then that penalty applies to the 20% withheld (but not to the 80% converted), so you also lose 10%*20%=2%.

[pb4uski]

Quote:

Originally Posted by 43210 In addition, if 10% early withdrawal penalty is applicable, then that penalty applies to the 20% withheld (but not to the 80% converted), so you also lose 10%*20%=2%.

No, because early withdrawal penalties do not apply to Roth conversions.

[RunningBum]

Quote:

Originally Posted by pb4uski No, because early withdrawal penalties do not apply to Roth conversions.

I think the part used to pay the taxes are subject to early withdrawal penalties since they are not actually converted.

[VanWinkle]

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Originally Posted by bingybear when you do a conversion you get taxed on all the $ removed from the IRA. If you use after tax $ to pay the taxed, then the $ to pay the tax are not taxed. If you withdraw $ from the IRA to pay the tax, you have to pay tax on the $ to pay the conversion tax. You actually need to pull even more as you as you now need to pay the tax on the tax... and so on. This really is just looking at the conversion and taxes at that time of the conversion.

The idea is to move as much money from the TIRA to the Roth IRA. Using money from the TIRA to pay taxes on the conversions just means that much less you can convert next time.

VW

[43210]

Quote:

Originally Posted by RunningBum I think the part used to pay the taxes are subject to early withdrawal penalties since they are not actually converted.

Exactly.

[VanWinkle]

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Originally Posted by 43210 Exactly.

Over 59 1/2, no penalty. Just the loss of ability to convert next time.

[Palmtree]

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Originally Posted by ERD50 Also consider 'harvesting' any Long Term Capital Gains, which are taxed at 0% in the 15% bracket. I haven't quite worked out the pros/cons of LTCG harvest versus Roth conversions, but it looks to be a moot point to me as I will need to sell some ETFs/funds for living expenses, and they all have some gains (some are about 50% unrealized gains). Not sure if I should harvest all the gains over the years, and then buy back what I don't need for living expenses, or do Roth Conversions. Maybe a topic for a different thread, and probably different moving puzzle pieces for different people. -ERD50

I had this discussion/debate over on the Boglehead forum. There was not a clear answer but many people weighted heavy on the side of Roth conversions on the assumption that your tax bracket will likely go up beyond 15% once you start taking social security.

[ERD50]

Quote:

Originally Posted by Palmtree I had this discussion/debate over on the Boglehead forum. There was not a clear answer but many people weighted heavy on the side of Roth conversions on the assumption that your tax bracket will likely go up beyond 15% once you start taking social security.

Right, but if I assume 15% bracket now and 25% later, that makes the delta on the ROTH conversions = 10%: 25% (rate on future t-IRA WD as income) minus the 15% (rate on conversion now) . And the delta on LTGC would be 15% (15% LTGC future and 0% now).

But I haven't factored time and ROTH tax-free growth into that (yet).

-ERD50

[pb4uski]

Quote:

Originally Posted by pb4uski No, because early withdrawal penalties do not apply to Roth conversions.

Quote:

Originally Posted by RunningBum I think the part used to pay the taxes are subject to early withdrawal penalties since they are not actually converted.

Yes, brain fart on my part.

[bingybear]

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Originally Posted by VanWinkle The idea is to move as much money from the TIRA to the Roth IRA. Using money from the TIRA to pay taxes on the conversions just means that much less you can convert next time.

For me I see it more important the measure cost of each method of conversion. For easy comparison I would like to see the same conversion amounts.

The way you describe would ignore the taxes, but these would be the same in both cases. You end up with different amount converted which I think is the point you want to show. However, the taxes paid externally are not shown as a cost for that case.

I guess I see a 10k conversion costing $12.5k (all from IRA) or $12k (taxes from after tax) more useful in my simple mind.

[VanWinkle]

Quote:

Originally Posted by bingybear For me I see it more important the measure cost of each method of conversion. For easy comparison I would like to see the same conversion amounts. The way you describe would ignore the taxes, but these would be the same in both cases. You end up with different amount converted which I think is the point you want to show. However, the taxes paid externally are not shown as a cost for that case. I guess I see a 10k conversion costing $12.5k (all from IRA) or $12k (taxes from after tax) more useful in my simple mind.

Agreed

VW

[kaneohe]

Another way to look at this situation (paying tax from TIRA or from outside taxable funds) is to examine the future values.

Have 10K TIRA and 2K outside funds. Assume 20% tax now and later.

1) Pay tax from TIRA. End up w/ 8K Roth and 2K outside funds. Assume values double in N yrs. Have 16K Roth and 4K- in taxable outside funds.
Total of 20K- . The - denotes the loss due to taxable drag on the outside funds.

2) Pay tax from outside funds. End up with 10K Roth.
Assume values double. Have 20K in Roth .

The two scenarios suggest that paying from outside funds, ending value >= to paying from TIRA with the difference being the tax drag on the outside taxable funds.

Don't know where the 20% tax rate came from but if 15% fed/5% state, then the fed tax rate could be 0% on QDIV/LTCG so the tax drag could be quite small if invested in tax efficient index funds. Still there is an inherent bias for paying from outside funds and the difference grows with the years.

[43210]

^ 20% is a standard amount withheld (in certain circumstances) which may be more or less than the final tax due.