ROTH conversion - do it now

[tuixiu]

Maybe I'm misunderstanding something but isn't your income now versus anticipated income in retirement a big factor in this, with obvious nod to the unknowns in taxes and income in the future?

It seems from cruising threads over the years many in here are extreme LBYM types who are living on 60% or less of pretty solid incomes, surely they are anticipating being in a far less painful tax bracket after they quit their job. And stop calling me Shirley.

 

[samclem]

That's probably the most likely scenario, but they could start means-testing existing qualified withdrawals.

Right. The money you put into a ROTH could continue to be withdrawn without tax (since it as taxed before going in), but the growth (also growth from ROTH 401Ks) would be subject to taxes above a certain level (whatever the new "hated rich" level turns out to be). Is it really fair, after all, for a worker to pay tax on all his income, but for the retired fat cats to not pay tax on this growth--money that they did nothing personally to earn? Of course not.

The amount subject to taxation will start high and rapidly decrease as the needs of the many grow.

And so it will go. Ants will feed the grasshoppers--just learn to like it. SWR= 3% for me, 1% for them. Smile--the govt loves a cheerful giver.

 

[ejman]

Right. The money you put into a ROTH could continue to be withdrawn without tax (since it as taxed before going in), but the growth (also growth from ROTH 401Ks) would be subject to taxes above a certain level (whatever the new "hated rich" level turns out to be). Is it really fair, after all, for a worker to pay tax on all his income, but for the retired fat cats to not pay tax on this growth--money that they did nothing personally to earn? Of course not.

The amount subject to taxation will start high and rapidly decrease as the needs of the many grow.

And so it will go. Ants will feed the grasshoppers--just learn to like it. SWR= 3% for me, 1% for them. Smile--the govt loves a cheerful giver.

Totally agree with you. In fact, I decided to go ahead and take the tax credit now (bird in hand and all that) by contributing to a regular IRA instead of a Roth. Some concerns about the Roth approach:

1) You pay taxes on the money going into the Roth now, then it goes into a process where the gains are supposedly not taxed. Two questions here - there may be no gains (in fact, there may be losses see current market for reference. If you need a longer frame of reference for market losses see Japan) and second, the promise not to tax may be broken in the future and I would venture to say in all probability it will be broken.

2) The assumption is that tax rates will be higher when withdrawing from a regular IRA in the future. And that may be so for RATES, not necesarily for my personal taxes if my income is much lower then and/or I'm able to shelter much more of my income by having a business or a farm (as I do now).

3) and finally, nobody knows what the future will be like (including yours truly) so I distinctly like paying less in taxes now

 

[lebron23]

great thread here. as an advisor this is one of the most important planning ideas we have been urging our clients to do. Mostly as a hedge against higher future tax rates. we have advised to make non-deductible contributions to IRA's until 2010 (if not eligible for Roth contributions) to build up basis and get a head start on the conversion in 2010. Now is good time to start converting some of your IRA's because balances are down so much- and the neat thing is you get a re-do each year (october of the following year deadline) if the market falls further. In 2010 take a good look at converting all other IRA's to Roth's as you will get to spread the tax out over 3 years and get a tax free loan in 2010. With the state of underfunded pensions and mamoth health care obligations along with huge deficits tax rates only have one place to go- and old uncle same knows of about 3 trillion dollars that have not been tapped- hint- that they can go increase their revenues from at any time. Just my two cents.

 

[73ss454]

lebron23, can you expand on how this works with Oct being the deadline. If I want to do Roth conversions for this year do I have till next year to get them done or do they have to be done by Dec. 31st this year?

 

[FinanceDude]

In 2010 take a good look at converting all other IRA's to Roth's as you will get to spread the tax out over 3 years and get a tax free loan in 2010.

Folks get TWO years, not THREE, although the income limits are thrown out.......

 

[ziggy29]

Folks get TWO years, not THREE, although the income limits are thrown out.......

I've been stockpiling cash in case I lose my j*b, at least until/unless my wife finds one. If we get through this rough patch relatively unscathed, I may be using that pile of cash to pay the taxes on some Roth conversions in 2010. Assuming Congress doesn't take that away next year.

 

[lucija]

<snip> However, since you are still young, it is also a good time to be putting as much into the market as you can. My inclination would be to put the extra money you will pay in taxes on the conversion into the market at these prices. Also, who knows what the rules are going to be regarding withdrawals from retirement accounts when you retire.

Could someone please point out to me the ammendment to the Constitution that says that Roths will never be taxed? I looked but couldn't find it. Short of that, the law can be changed at anytime.

True, everyone’s circumstances are different and it is also true that no one knows what future holds… It was not my intention to advocate 100% ROTH approach. Personally, I would only invest in ROTH after all our other tax-deferred options are exhausted. For us this makes sense because (1) out marginal tax rates are high and (2) we’re in a position to invest beyond the 401k IRS limit.

In my opinion, precisely because the future is so unknown one should, at least attempt, to hedge the tax risk by holding (currently) tax fee, tax deferred and taxable accounts.

Maybe I'm misunderstanding something but isn't your income now versus anticipated income in retirement a big factor in this, with obvious nod to the unknowns in taxes and income in the future?

It seems from cruising threads over the years many in here are extreme LBYM types who are living on 60% or less of pretty solid incomes, surely they are anticipating being in a far less painful tax bracket after they quit their job. And stop calling me Shirley.

So true… but couldn’t the future RMDs change this equation for some? I can see how some folks may be forced to pull out more than they need from traditional IRAs and therefore jump into the next tax bracket. Also, a combination of traditional and ROTH withdrawals could keep future tax burden smaller. Again, who knows what future holds.

On a separate note, in the future, I foresee higher taxation across the board. I don’t know whether ROTH will ever be taxed, but I would not be surprised if additional contributions/conversion are disallowed at some point in the future. For some reason, I see the most likely way to increase tax revenue is to institute VAT-like tax in addition to current fed/state/other taxes. Yes, this would indirectly trigger ROTH taxation, but it is not like any other saving vehicle would be immune to this type of tax.

 

[lucija]

<snip> we have advised to make non-deductible contributions to IRA's until 2010 (if not eligible for Roth contributions) to build up basis and get a head start on the conversion in 2010. <snip>

I hope your clients do not have large traditional IRAs ready. If so, they may be in for a nasty surprise at tax time.

 

[FinanceDude]

True, everyone’s circumstances are different and it is also true that no one knows what future holds… It was not my intention to advocate 100% ROTH approach. Personally, I would only invest in ROTH after all our other tax-deferred options are exhausted. For us this makes sense because (1) out marginal tax rates are high and (2) we’re in a position to invest beyond the 401k IRS limit.

In my opinion, precisely because the future is so unknown one should, at least attempt, to hedge the tax risk by holding (currently) tax fee, tax deferred and taxable accounts.



So true… but couldn’t the future RMDs change this equation for some? I can see how some folks may be forced to pull out more than they need from traditional IRAs and therefore jump into the next tax bracket. Also, a combination of traditional and ROTH withdrawals could keep future tax burden smaller. Again, who knows what future holds.

On a separate note, in the future, I foresee higher taxation across the board. I don’t know whether ROTH will ever be taxed, but I would not be surprised if additional contributions/conversion are disallowed at some point in the future. For some reason, I see the most likely way to increase tax revenue is to institute VAT-like tax in addition to current fed/state/other taxes. Yes, this would indirectly trigger ROTH taxation, but it is not like any other saving vehicle would be immune to this type of tax.

If Congress does disallow further ROTH contributions and such, they will probably have to put in a provision that allows a one-time conversion to it or something. If they get rid of 401K tax deferral, they will have to make other concessions, because it will be an unpopular move, no matter how excited Congress gets about getting an "extra $80 billion" a year......

 

[lucija]

I've been stockpiling cash in case I lose my j*b, at least until/unless my wife finds one. If we get through this rough patch relatively unscathed, I may be using that pile of cash to pay the taxes on some Roth conversions in 2010. Assuming Congress doesn't take that away next year.

I, too, hope the law does not get changed. I would use it on an ongoing basis as a means of funding ROTH.

 

[FinanceDude]

I hope your clients do not have large traditional IRAs ready. If so, they may be in for a nasty surprise at tax time.

 

[Nords]

lebron23, can you expand on how this works with Oct being the deadline. If I want to do Roth conversions for this year do I have till next year to get them done or do they have to be done by Dec. 31st this year?

While we're waiting on Lebron, I'll point out that a Roth conversion has to be completed before 31 December. (That's different that the contribution deadline.) Lebron is referring to a re-characterization of a Roth conversion-- a do-over-- done when the market falls further and the taxpayer wants to avoid paying the higher taxes on the first conversion in hopes of being able to better time the market on the second attempt.

IRS Pub 590-- fascinating reading. The IRS website also has links to explain the 2010 conversion benefits, as does Fairmark's website.

http://www.irs.gov/pub/irs-pdf/p590.pdf
Roth "Option" Set to Expire
Guide to Roth IRA, 401k and 403b Retirement Accounts

BTW one of the biggest advantages of a Roth conversion is that the owner is no longer subject to RMDs. In a conventional IRA the only option to lessen the tax impact of an RMD would be to donate it to charity.

OK, you financial advisors may now resume beating up on each other...

 

[FinanceDude]

OK, you financial advisors may now resume beating up on each other...

 

[73ss454]

Thanks Nords!

 

[ejman]

On a separate note, in the future, I foresee higher taxation across the board. I don’t know whether ROTH will ever be taxed, but I would not be surprised if additional contributions/conversion are disallowed at some point in the future. For some reason, I see the most likely way to increase tax revenue is to institute VAT-like tax in addition to current fed/state/other taxes. Yes, this would indirectly trigger ROTH taxation, but it is not like any other saving vehicle would be immune to this type of tax.

Well, we LBYM types would certainly know how to deal with VAT!

 

[Koolau]

Since ER in '05, I've been annually converting enough Trad. IRA $ to ROTH IRA in order to use up the 25% tax bracket. I may extend that into the 28% bracket. Rough calc. suggests that by the time I reach RMD at 70.5, I would be forced into at least the 28% bracket (if not higher). Guess it's good news/bad news. Hate paying taxes, but nice to have enough in IRAs that RMDs are significant.

Certainly hope we don't go to a VAT tax - especially not in addition to all other current types of taxes. Double, even triple taxation would ensue (maybe quadruple or higher if you live in Hawaii!!) as you withdraw your ROTH money.

 

[Nords]

Certainly hope we don't go to a VAT tax - especially not in addition to all other current types of taxes.

I'm not sure whether a VAT or an excise tax is more painful...

 

[baldeagle]

Originally Posted by baldeagle
I already did my annual conversion last February, hoping further growth of converted assets would take place in Roth accounts. I convert enough annually to max out the 15% bracket. Now, of course, I wish I'd waited. So many more shares could have been converted at today's prices for the same tax bill. C'est la vie.

January 2009 is coming soon, and if the market's still down I will get a larger share conversion this time around.

Couldn't you do a recharacterization to effectively "undo" this conversion and then redo? There are some rules that you'd have learn about how/when to do redo.

From Fairmark.com
Market losses after conversion. You made a good conversion and you still like the idea of a conversion — but you wish you hadn't done it so soon. Your Roth IRA suffered market losses after the conversion, and that means you would report less tax if you were converting now. Here again you can use this rule to undo the conversion — and then do a new conversion later. If your investments are still at the lower value when you reconvert, your tax cost will be lower. Regulations place some restrictions on your ability to do this, but in the right situation you can still use this technique to lower your taxes.

Kaneone,

Yes I could recharacterize, and I have given some thought to doing so. But that has too many negative side effects:

• I lose a year's worth of conversion when I re-characterize. I am on a plan to convert to the max of the 15% bracket every year until age 70.5, trying to minimize amount of MRDs thereafter.

• Re-characterization of the original dollar amount would require me to put more Roth shares back into IRA than what I converted. That not only undoes this year's conversion but part of last year's as well. Again, contrary to my plan.

• Those additional shares that would go back to IRA originally had taxes paid on their conversion. How do I get those taxes back?

I'm just not seeing a benefit to re-characterization for my situation. Do you?

 

[kaneohe]

baldeagle,

I've never done a conversion, much less a recharacterization, in my life so I'm sure you know more than I do. I've been trying t learn tho and have seen some interesting stuff elsewhere. I may have some it confused so pls take it as food for thought only.

"I lose a yrs worth of conversion"---is that because after you recharacterize, you can't convert again till next yr? (and 30 days from the recharacterization). My impression was that is true for those recharacterized $$ but that you could convert other funds (if available) and, if they are coming from the same account, you might want to do that first to show they were not the recharacterized funds.

"Recharacterization takes back more shares than converted this yr and causes double taxation".......perhaps too late for this time around, but what I think I learned is that this problem was caused by putting your conversion into an existing Roth?
Depending on the performance of the other investments in the Roth, you might end up better or worse when you recharacterized. The fix is to put your conversion into a separate quarantine acccount until you are sure you are not going to recharacterize.....that way, if you do rechacterize, the same shares will come out. You could merge the Roths later once you know you will not recharacterize but should quarantine new conversions.

As for the tax effects, I haven't worked through any real examples so I don't know but if you will gain some from recharacterizing and will lose out from previous taxes paid, I guess you would have to net them out and see if you had a net gain or loss from the composite of all your actions. Not something to do on a whim.

The other discussions I saw were on irahelp.com and fairmark.com.

 

[Nords]

I lose a year's worth of conversion when I re-characterize. I am on a plan to convert to the max of the 15% bracket every year until age 70.5, trying to minimize amount of MRDs thereafter.

You'd lose a year that you wouldn't need anyway. You may have lost a year of your schedule, but you've probably "lost" enough assets during that time that you wouldn't need that extra year. You'd be converting fewer assets (and paying lower overall taxes) so you'd be able to fit the whole conversion within a shorter timeframe.

Re-characterization of the original dollar amount would require me to put more Roth shares back into IRA than what I converted. That not only undoes this year's conversion but part of last year's as well. Again, contrary to my plan.

Circumstances have changed, so change the plan. Fewer assets don't need as much time to convert. The money that's going back into the traditional IRA (undoing part of another conversion) is also being recharacterized but it's not being taxed again. It's just moving numbers around on IRS Form 8606.

Those additional shares that would go back to IRA originally had taxes paid on their conversion. How do I get those taxes back?

File an amended return or, as I've seen some locals do, pay estimated taxes and (if you meet the requirements) extend your filing until Oct. The latter way allows you to make the final recharacterization decision before filing your tax returns.

At some point the tax savings (especially in the 15% tax bracket) isn't worth the hours it'd take to complete the recharacterization/amendment/reconverting process. In our case we were able to substantially accelerate our conversion timeline and our time/efforts are better spent on other, more productive/profitable, projects. But I'm sure that a number of extremely patient tax accountants are making a great living out of filing paperwork for frustrated market timers.

Kaneohe's pointed out two of the Internet's best websites for digging into the details. The CPAs on Ed Slott's board, in particular, publish a number of articles and seem to live to answer the most obscure, abstruse questions.