Mechanics of distribution

[Gumby]

I expect to retire in 15 months and I am thinking about the mechanics of pulling money from my portfolio. We currently have money in various tax deferred accounts (Traditional IRA/401k/403b/457) and a smaller amount in Roth IRAs. Pensions and social security will fully pay all our current spending, so I have substantial flexibility.

Assume that I want to withdraw $50k from my tax deferred account every year starting at 60, so that I can head off a big RMD shock in ten years. Assume that all of that withdrawal occurs in the 22% tax bracket, which means I'll owe $11k in taxes.

Which of the following should I do?

A. Roth convert all $50k and then withdraw $11k from the Roth to pay my taxes.

B. Roth convert $39k and directly withdraw $11k from my tax deferred to pay the taxes.

 

[samclem]

Which of the following should I do?

A. Roth convert all $50k and then withdraw $11k from the Roth to pay my taxes.

B. Roth convert $39k and directly withdraw $11k from my tax deferred to pay the taxes.

Okay, I'll put my ignorance on full display: What's the thinking behind doing a Roth conversion of money you are withdrawing for that year's spending? Is it to avoid paying taxes on gains from the money during the 12 months of spend-down?

 

[Gumby]

Okay, I'll put my ignorance on full display: What's the thinking behind doing a Roth conversion of money you are withdrawing for that year's spending? Is it to avoid paying taxes on gains from the money during the 12 months of spend-down?

The only withdrawal from the Roth is to pay the taxes, because pensions/SS cover our living expenses. The reason I need to withdraw from the tax deferred is to avoid gigantic RMDs later.

It is not obvious to me that there is any difference at all in the two options I presented, but I want to make sure I'm not overlooking anything.

 

[Texas Proud]

I am not thinking too hard.... but is there a difference between the two?

I do not see one...

 

[samclem]

The only withdrawal from the Roth is to pay the taxes, because pensions/SS cover our living expenses. The reason I need to withdraw from the tax deferred is to avoid gigantic RMDs later.

It is not obvious to me that there is any difference at all in the two options I presented, but I want to make sure I'm not overlooking anything.

Thanks, got it now.

The only difference I can see between the two options would involve avoiding taxes on the "float" during the time between your conversion/withdrawal and when you actually pay the IRS. For instance, if the rules allow you to do the conversion/withdrawal in Jan and not pay the taxes until Dec (i.e., no "estimated payments" due to the IRS during the year, or when the conversion is done), then you'd have gains from the interest/dividends/stock appreciation on the $11K you plan to use to pay taxes, and it would be better if those gains occurred tax free (forever) inside the Roth. Sorry, I don't know the mechanics of when taxes must be paid on a Roth conversion.

 

[samclem]

It looks to me like converting it all ($50K, including the $11K that you'll need to pay the taxes) has a slight advantage. Rationale:
-- While the taxes on the conversion are officially due when the conversion is accomplished (more here), there are ways to avoid any penalty (e.g. the "safe harbor" rules apply, so no penalty would be due if you'd withheld as much as your previous year's liability. I think you could also withhold/make an estimated tax payment at the end of the year and it would count the same as if you'd done it earlier (check on this, I'm not a tax wiz)). So, that $11K will be in your Roth IRA for up to 12 months earning interest/dividends that will never be taxed. If, instead, you'd simply withdrawn the $11k from your tIRA/401K, etc in Dec to pay the taxes, those earnings would remain in your tIRA/401K and would add (a little) to the RMD/tax torpedo problem you are trying to avoid. If instead you withdrew the $11K in Jan and put it in a regular taxable account for 12 months, of course the earnings would also be taxable (though at least dividends/CG, etc might get a lower rate than they'd be subject to in your IRA/401K, where they'd be taxed at the earned income rate).

I'm sure folks with more savvy will chime in, but that's the way things look to me.

 

[jazz4cash]

I'm doing something similar already (for the same reason) and using method "B", but I never considered doing it any other way. I guess I need to review my options. I'm leaning to something in between A and B, like maybe using a fixed account to hold the amount for taxes and taking a distribution with 100% withholding from that account at the end of the year which I think is easier than filing estimated taxes. Some institutions don't permit withholding 100% but I think mine does.

So, you can withdraw the 11k before 5 years because it is part of your contribution, but the earnings have to stay in the account?

 

[Texas Proud]

I think that the people who are talking about earnings on the $11K are right in a way, that should not be entering the equation IMO...

First, no mention of when he is withdrawing... he could be doing it evenly over 12 months...

Second, what about when the market goes down? Sure, if the market goes up there could be a bit more income, but that also means the opposite can happen....

Third, probably not enough income on that money to worry about...

 

[Sunset]

Plan A) will be better most years due to the tax dividends/interest remaining in the ROTH, assuming you pay at the end of the year. However, in a declining market, it will be better to pay off the tax bill immediately, or keep the payment money in purely interest earning CD's.

I do think the difference will be pretty small between the two methods.

Are you sure your limit for conversion is $50K, to the top of the 22% range ?

 

[OldShooter]

... Assume that I want to withdraw $50k from my tax deferred account every year starting at 60, so that I can head off a big RMD shock in ten years. Assume that all of that withdrawal occurs in the 22% tax bracket, which means I'll owe $11k in taxes. ...

Boy, I'd want to do some serious spreadsheet work before I decided that was a good strategy. I really like having a free loan from the government and earning returns on it. It all depends on what after-dollars you assume you can earn in a tax-sheltered account vs what you can earn in a taxable account.

If you are charitably inclined at all, remember that you can take some of your RMD without its affecting your AGI/tax bracket: https://money.usnews.com/money/reti...your-required-minimum-distribution-to-charity

 

[Gumby]

Are you sure your limit for conversion is $50K, to the top of the 22% range ?

I just used that number for a hypothetical to see how it works without adding too many wrinkles. It will take more than that to get to the top of the 22% bracket. And, to the best of my knowledge, I can Roth convert an unlimited amount, so long as I'm willing to pay taxes in whatever bracket results.

 

[bizlady]

Its an interesting dilemma we are also considering. Converting to the 12% tax bracket is a no brainer, but we are also considering converting to the 22% bracket for the next years to avoid a likely minimum 25% tax later with RMD and allow the converted amount to grow tax free.

 

[Gumby]

Boy, I'd want to do some serious spreadsheet work before I decided that was a good strategy. I really like having a free loan from the government and earning returns on it. It all depends on what after-dollars you assume you can earn in a tax-sheltered account vs what you can earn in a taxable account.

That is actually the meta question. Should I draw money from tax deferred now and pay the taxes, or leave in the tax deferred until I start RMDs? If I would be in the same tax bracket now and at age 70, that should be a wash. If, however, the RMDs would drive me into a higher bracket, maybe I would be better draining money off now at a lower bracket so the eventual RMDs would be small enough to also be in a lower bracket.

Assume I currently have $2 million in tax deferred. Assume I can take out $100k per year and stay within the 22% bracket. Assume I have 10 years until RMDs are required. Assume I earn 7.2%/yr on investments. Assume tax law stays the same.

Case 1 - Take money out every year

$100k from IRA. $22k to tax. $78k to Roth.

After ten years, I will have ~ $1.13 million in Roth and ~$2.64 million in IRA

RMD for the 1st year is 3.65% of $2.64 million, or ~ $96k. Still in 22% bracket.


Case 2 - Leave money in IRA until RMDs

After ten years, I will have zero in Roth and ~ $4.1 million in IRA

RMD for 1st year is 3.65% of $4.1 million, or ~$150k. Driving me well into the 24% bracket

 

[OldShooter]

... Driving me well into the 24% bracket

With respect, brackets don't matter. Net after-tax dollars matter. From the info you posted I might be able to do that calculation but I am too lazy to try.

 

[Hermit]

Don't forget that your income impacts Medicare costs when you reach that age. My expenses are also covered by pension and the late DW's SS. Personally, I just take out $28K and pay the taxes to equal my total income when I begin SS on my account at age 70. I plan on doing QCD distributions to cover RMDs for several years, so maybe the withdrawal timing differences are not so important to me.

 

[OldShooter]

... Should I draw money from tax deferred now and pay the taxes, or leave in the tax deferred until I start RMDs? If I would be in the same tax bracket now and at age 70, that should be a wash. ...

(just re-read your post) This IMO is not correct. If you take money out early and pay the taxes, then invest the balance, your net dollars will be less than if you left the dollars in the sheltered account and earned a real return on your zero-interest loan from Uncle.

For example, if you withdrew X dollars at age 60, paid taxes, and netted $10K then you will earn a (taxable) % based on that $10K. If OTOH you left $X in the tax sheltered account and invested $X to earn the same %, then withdrew it 10 years later (at the same tax rate) you would net more dollars due to (basically) arbitrage between the zero rate Uncle is giving you and the % rate you are able to earn. Then when you draw out your arbitrage profits, whatever is left after taxes is free money.

 

[ChrisC]

Hmmmm, we've been Roth converting around $60K the last several years, which places us near the top of 1st tier for current IRMAA, which ends at $214K, MAGI. With the next tax brackets, we'll probably convert much more, but this will probably trip us (it's really just my wife who has Medicare Part B) into the 2nd tier of IRMAA.

I'm wondering why Gumby can't withhold enough from his pensions (and later Social Security if he takes it before 70) to pay for the uptick in Federal or State income taxes resulting from the conversions? This is what I do and in fact I just increased my pension withholding to take into account the increase in Roth conversions we'll be doing this year, even though my tax bracket went from the old 28% to the new 22% bracket

 

[Fleur58]

Are you in a state that does not tax Roth IRA conversions? My state considers it income and charges 7.5% so I have to add that tax on in addition to the federal tax liability. I am also considering converting this year.

If applicable, you should also calculate if any of your Trad IRA money was non deductable, because it could reduce your federal tax liability. In my case, I have $32,500 in non deductable contributions (per IRS Form 8606) which translates into $676 of my desired conversion of 20K is not taxable.

 

[gauss]

A. Roth convert all $50k and then withdraw $11k from the Roth to pay my taxes.

B. Roth convert $39k and directly withdraw $11k from my tax deferred to pay the taxes.

I have been doing (B) but I am younger than you. My Roth distributions are non-qualified because I am not yet 59 1/2. As such I have a much higher level of responsibility to track the details of my Roth accounts (see part 3 of IRS form 8606 to see what I mean).

This should be required reading for any ER who plans to living on (untaxable penatly-free) Roth distributions before age 59 1/2 as opposed to the other option of the 72(t) plans. I was quite surprised about the amount of record-keeping that I needed to take a nonqualified Roth distribution.

OP is over 60 so as long as his first Roth IRA and Roth 401k have been in place for at least 5 years, the distributions will be "qualified" ie 1099-R code Q so that part III of 8606 is not required and complicated Roth basis tracking and reporting would not be needed.

-gauss

 

[pb4uski]

....Which of the following should I do?

A. Roth convert all $50k and then withdraw $11k from the Roth to pay my taxes.

B. Roth convert $39k and directly withdraw $11k from my tax deferred to pay the taxes.

No difference... in each case you have $50k decrease in tax-deferred, $50k of taxable pension income, $11k in tax and $39k added to your Roth.... six of one or one-half dozen of the other.

 

[Gumby]

(just re-read your post) This IMO is not correct. If you take money out early and pay the taxes, then invest the balance, your net dollars will be less than if you left the dollars in the sheltered account and earned a real return on your zero-interest loan from Uncle.

For example, if you withdrew X dollars at age 60, paid taxes, and netted $10K then you will earn a (taxable) % based on that $10K. If OTOH you left $X in the tax sheltered account and invested $X to earn the same %, then withdrew it 10 years later (at the same tax rate) you would net more dollars due to (basically) arbitrage between the zero rate Uncle is giving you and the % rate you are able to earn. Then when you draw out your arbitrage profits, whatever is left after taxes is free money.

You've given me something to think about.

Just to simplify. Lets say I only have $100 in my IRA. I take it out and put $78 in a Roth and pay taxes with $22. Then I let it sit in my Roth for 10 years at 7.2% per year. I'll end up with $156 that I can spend.

Alternatively, I leave the $100 in my IRA and let it grow for 10 years at 7.2%. Then I have $200 in my IRA. I take all of this out and must pay $44 in taxes. I still end up with $156 that I can spend.


And if the $200 drives me into a higher tax bracket, then I'll pay more tax and end up with less to spend.

 

[OldShooter]

You've given me something to think about.

Just to simplify. Lets say I only have $100 in my IRA. I take it out and put $78 in a Roth and pay taxes with $22. Then I let it sit in my Roth for 10 years at 7.2% per year. I'll end up with $156 that I can spend.

Alternatively, I leave the $100 in my IRA and let it grow for 10 years at 7.2%. Then I have $200 in my IRA. I take all of this out and must pay $44 in taxes. I still end up with $156 that I can spend.


And if the $200 drives me into a higher tax bracket, then I'll pay more tax and end up with less to spend.

Yup. Bringing the Roth into the picture changes things vs just withdrawing the money and putting it in a taxable account, which is what I assumed from your literal text. In the whole context of the post, I probably should have considered the Roth angle.

 

[pb4uski]

You guys are talking about two different things.

OldShooter is talking about taking out tax-deferred and then investing in taxable.

Gumby is talking about taking out of tax deferred and rolling into a Roth.

You're both right. If the marginal tax rate is the same then one should be indifferent to a rollover and paying the taxes vs staying in tax deferred. But if you have a choice between staying in tax deferred or withdrawing, paying the taxes and investing in taxable then there is a slight difference because of interest on earnings in the taxable account.

To expand Gumby's example, say you take $100 out of tax deferred, pay the $22 in tax and invest the $78 in taxable and earn 7.2%/year and pay 22% in taxes on those earnings (an after-tax rate of 5.6%)... after 10 years your $78 has grown to $135 that you can spend (the $21 difference is because of taxes on annual income in the taxable account).

 

[Gumby]

You guys are talking about two different things.

OldShooter is talking about taking out tax-deferred and then investing in taxable.

Gumby is talking about taking out of tax deferred and rolling into a Roth.

You're both right. If the marginal tax rate is the same then one should be indifferent to a rollover and paying the taxes vs staying in tax deferred. But if you have a choice between staying in tax deferred or withdrawing, paying the taxes and investing in taxable then there is a slight difference because of interest on earnings in the taxable account.

To expand Gumby's example, say you take $100 out of tax deferred, pay the $22 in tax and invest the $78 in taxable and earn 7.2%/year and pay 22% in taxes on those earnings (an after-tax rate of 5.6%)... after 10 years your $78 has grown to $135 that you can spend (the $21 difference is because of taxes on annual income in the taxable account).

Thanks for synthesizing our positions. This has been a valuable exercise for me.

 

[Sunset]

Its an interesting dilemma we are also considering. Converting to the 12% tax bracket is a no brainer, but we are also considering converting to the 22% bracket for the next years to avoid a likely minimum 25% tax later with RMD and allow the converted amount to grow tax free.

For us, we put money in at the 25% marginal bracket, so taking some out including within the 22% rate still seems like a win of at least 3%.
Actually it's better than that as only the last part is 22% , the blended rate will be lower.