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Roth conversion question
Old 12-11-2010, 09:02 AM   #1
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Roth conversion question

You sometimes read that you should do Roth conversions by filling up the 15% bracket
so that you are converting at one of the lower rates. Suppose you have 45K of
interest, pension , capital gain and dividend income and 13K of TIRA converted to Roth. You also have 32 K of taxable SS (85% of total 37.5K SS, some rounding here). This makes 90K of AGI. Assuming MFJ and deductions/exemptions of 22K, you have 68K of taxable income which is the top limit of the 15% bracket. Therefore the Roth conversion has been made at the 15% rate and cost the
taxpayer 1.95K (15% of 13K conversion). True?
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Old 12-11-2010, 09:52 AM   #2
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Didn't check your numbers, but if $68k of TI is the top of the 15% marginal rate then what you stated sounds right to me. Just make sure that you have correctly calculated the taxable portion of SS including the conversion amounts and not before. If you use tax software it should be easy to verify in a what-if worksheet.
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Old 12-11-2010, 12:14 PM   #3
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Quote:
Originally Posted by kaneohe View Post
You sometimes read that you should do Roth conversions by filling up the 15% bracket
so that you are converting at one of the lower rates. Suppose you have 45K of
interest, pension , capital gain and dividend income and 13K of TIRA converted to Roth. You also have 32 K of taxable SS (85% of total 37.5K SS, some rounding here). This makes 90K of AGI. Assuming MFJ and deductions/exemptions of 22K, you have 68K of taxable income which is the top limit of the 15% bracket. Therefore the Roth conversion has been made at the 15% rate and cost the
taxpayer 1.95K (15% of 13K conversion). True?
That is how I would see it. The portion of one's taxable income (Adjusted AGI - deductions-exemptions) over a given bracket level "c" but below the next higher level will be taxed at that level "c". Since the Roth conversion is completely voluntary, in a sense its taxation level is floating on the top of all other taxable income.

Key to remember is that it's the sum of taxable income that matters- not at what rate components of this income are being taxed. For example, on identical taxable income I have paid total tax as much as 50% different, depending on the components of that income. However, a conversion in each case would take place at the same marginal rate.

This stuff is hard to talk about and be clear; I really suggest doing what others suggest-a dry run with tax software.

Ha
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Old 12-11-2010, 07:14 PM   #4
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Ha is right, this IS complex. I spent a couple of hours this afternoon studying different scenarios. I came up with the following rules and guidelines. Please tell me if you see any mistakes. Hopefully this will be helpful to others, but I'm doing it for my own benefit since this will be my strategy unless someone finds flaws with it.

Sorry if I don't explain this clearly. If someone has looked at conversion and the 15% bracket closely, hopefully they'll understand what I'm talking about. If someone hasn't looked at this before, you should definitely plug in your own numbers into a tax program to see for yourself.


The top of 15% bracket is $34K (single). For couples, use $68K. This is the 2010 numbers and it will change.

Dividends & Long Term Cap Gains for someone in the 15% bracket are 0%, if you keep your TOTAL income in the 15% bracket, including Divs and LTCG. In many places I just call this dividends, but I mean both. Also, this only refers to qualified dividends. Non-qualified dividends count as income.

Roth IRA converted money is Income.

The $34K limit is after deductions and credits. Standard deduction in 2010 is $5700 ($11400 if married, 2010 numbers). If you itemize it could be more. Don't forget to use this when pushing to the top of the 15% bracket.

After $34K (top of 15% bracket) COMBINED income/conversion + div/LTCG, every new dollar converted is taxed @ 15%, PLUS a dollar of dividends is moved from free to taxable at 15% up to another $34K or totals divs/LTCG, whichever is smaller.

So for example, if you have $14K in income after deductions and $20K in dividends, you pay up to 15% on the $14K income (there is some in the 10% bracket) and 0% on dividends.

But if you have $20K in income, you pay up to 15% on that income, plus 15% on $6K of dividends. $14k of dividends remain untaxed. So by converting $6K over the 15% bracket, that 6K was taxed @15% plus you moved $6K in dividends in to taxable @ 15%.

Another way to view: In the first $34K (top of 15% bracket), dividends are FREE. After that, each dollar of income (Roth IRA conversion) is taxed at 15%. Every dollar converted also moves a dollar to 15% tax, so essentially a 30% tax on each dollar converted over this limit.

Once income (without dividends/LTCG) hits $34K, all dividends are now taxed @ 15%, so there is no additional 15% hit because you aren't pushing any more dividends from 0% to 15%. Income is now in the 25% bracket, but there is no additional penalty of pushing divs/LTCG into taxable income, so the tax rate drops from 30% to 25% on the extra dollar. Seems surprising but I really think this is true from looking at how the Qualified Dividends and Capital Gains Worksheet calculations are done.

So, for example, if you have $34K in income, and $20K in dividends, you pay up to 15% on the $34K income and 15% on the 20K divs.

If you have $84K in income, you pay 25% on that extra $50K, and still just pay 15% on the divs.

If you have a large IRA, when minimum required distributions hit at 70.5, you may be crossing the 15% line if you donít convert at all. This is an important consideration. Since again, once you cross the 15% line, you are pushing dividends from 0% to 15%, effectively pushing your tax rate to 30% for dollars beyond that until all divs are taxed.

BOTTOMLINE:
1. Always convert just up to the 15% cap (unless income in later years will stay in the 10% bracket)

2. The goal should be to have income up to the 15% cap in every year rather than convert any money when it will be taxed above 15%. Keep this in mind when talking about the next points.

3. If for some reason, income alone will hit the 15% cap, it is probably worth converting all the way to the 28% level because that is better than paying 30% in later years if you cross the 15% line with MRDs. However, the more you convert, the less the IRA MRD, so the less likely youíll cross the 15% line. See next item, which is related to the previous item

4. If dividends alone are pushing you to the 15% cap every year, the effective rate on any conversion or MRD is 30%, so, it is better to convert at 25% and 28% when you have an opportunity those years where you already have some income. But, if dividends are lower, itís ok to leave some IRA to distribute in later years if you can still stay under 15%.

An example of point 4 is that I'll be working a partial year next year, so I'll already be close to the top of the 15% bracket on income alone. So, it seems it would be good to convert a large chunk, all the way up to the end of the 28% bracket because that's better than paying at the 30% rate later.

Other considerations:

- Income producing stocks and bonds should be in your Roth IRA and traditional IRA as much as possible, to give you more room to convert and stay in the 15% bracket.

- Using tax-exempt rather than taxable bonds will also help keep you in the 15% bracket, but see if the reduced return on tax-exempt bonds is worth it.

Factors I haven't taken into account:

- tax rates could go up or down--more likely up unless a VAT becomes the preferred method of increasing tax revenue. Also, I don't think the 15% class will be hit too hard with taxes.

- inflation could more easily push one above the 15% tax rate if the brackets rise slower than inflation. This implies that you should tend to convert now where it seems to make sense.

- taxation on dividends and cap gains may change, so this will have to be adjusted then. Most likely the change will be for the worse, like taxing them at regular income rates, which again implies you should convert now where things seem otherwise even.
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Old 12-11-2010, 07:53 PM   #5
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Quote:
Originally Posted by kaneohe View Post
You sometimes read that you should do Roth conversions by filling up the 15% bracket
so that you are converting at one of the lower rates. Suppose you have 45K of
interest, pension , capital gain and dividend income and 13K of TIRA converted to Roth. You also have 32 K of taxable SS (85% of total 37.5K SS, some rounding here). This makes 90K of AGI. Assuming MFJ and deductions/exemptions of 22K, you have 68K of taxable income which is the top limit of the 15% bracket. Therefore the Roth conversion has been made at the 15% rate and cost the
taxpayer 1.95K (15% of 13K conversion). True?
If you are taking an itemized deduction, the only caveat I would add (and this is a second-order effect unlikely to affect your decision) is that doing a 13K conversion could reduce your itemized deduction by $975 (7.5% of 13K) if your medical deduction is at least this amount. This would raise your tax by an additional $146 (15% of 975). So your marginal tax rate on the conversion would be increased by 1.1 percentage points to 16.1%.
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Old 12-11-2010, 08:15 PM   #6
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Thanks all for the replies. RB.......wow......good thing they don't charge us by the word to post here. OK....true confession time. I was inspired by T-Al's post (which was a learning or perhaps a re-learning experience for me) and thought there might be some educational value in this one. I completely agree w/ all who said to use software or a tax calculator for a double check.
This is similar in some ways to the case where you misunderstand how the 0% capital gains works and have too much ordinary income. Then you can get in a situation where instead of paying 0% on LTCG, you pay 15% for the extra ordinary income and then 15% on the displaced LTCG which makes for an effective marginal rate of 30% as was mentioned in that other post.

In the OP here, I believe it is true that the SS is in the saturation region where 85% of it is taxed and all of the taxable income is within the 15%
bracket. The deduction/exemptions may look weird to some but it is a std deduction for ancient folks w/ real estate taxes. The catch in this one is that although the facts are true w/ the Roth conversion of 13K, it is not true
if the Roth conversion amount is removed.........that is to say, the amount of SS taxed is not 85% of SS.....in fact it is less. Therefore the addition of 13K of Roth conversion not only adds 13K to the 15% bracket. It also adds more taxable SS to the 15% bracket. No guarantees on the numbers but I think the effective marginal rate for adding 13K of Roth conversion is more like 25% even tho in the end, the taxable income ends up at the top of the 15% bracket. I believe I have seen talk of even higher marginal brackets.... if SS is not being taxed w/o the Roth to start with.

So, if you have SS, and are Roth converting some thought and caution may be useful. I knew about this factor but because it didn't apply to me at the time, it was kind of buried in memory and a surprise to me when I discovered or rediscoved it.
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Old 12-11-2010, 09:36 PM   #7
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Originally Posted by kaneohe View Post
if the Roth conversion amount is removed.........that is to say, the amount of SS taxed is not 85% of SS.....in fact it is less. Therefore the addition of 13K of Roth conversion not only adds 13K to the 15% bracket. It also adds more taxable SS to the 15% bracket. No guarantees on the numbers but I think the effective marginal rate for adding 13K of Roth conversion is more like 25% even tho in the end, the taxable income ends up at the top of the 15% bracket.
Yes, this is the infamous SS tax torpedo that we have discussed many times before in this forum. According to my tax spreadsheet (for tax year 2010), with only 45K of other income, 22.788K (61%) of SS is taxable. Adding in 13K for the Roth conversion brings the taxable portion of SS up to 31.875K (85%). This extra 9.087K of SS is taxed at 15%, adding an additional 1.363K to the 1.95K tax on the 13K conversion. So the effective marginal tax rate on the conversion is actually 3.313K / 13K , or 25.5%.
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Old 12-11-2010, 10:16 PM   #8
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Man, this is complicated! I've never used tax software before, and didn't think I would need it after retiring, since I don't have a taxable account and all my income will either be taxable as ordinary income (pension, TIRA withdrawals) or not taxable at all (Roth withdrawals). I still haven't grasped this Roth conversion info, and I think I need to, because most of my savings will be in a tax-deferred account so I will eventually have to take RMD's. It looks like tax software is by far the easiest way to figure out whether a conversion is advantageous or not.

But maybe it's no big deal. I think (if the rules stay the same) 85% of my SS will be included in my taxable income as soon as I start drawing benefits. That being the case, is there any amount of RMD that would result in a decrease of my after-tax income? IOW, is there any circumstance in which the additional income tax due because of an RMD would be a larger amount of money than the RMD itself? Unless there's a possibility of that happening, I think I'm not going to worry about it. If I've got to have a problem, "too much money" is a good one to have.
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Old 12-11-2010, 11:39 PM   #9
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One suggestion is to do an estimate of what might happen if you DON'T convert now. i.e., at some point, RMDs become the controlling "event" and then whatever tax laws at that time will determine you taxes (and effective tax rates). So if you can guesstimate what your total qualified nest egg will become by age 70 and divide by your (gummint estimated) lifetime, you'll get your estimated RMD to play with. Not making a suggestion one way or another as far as converting (or not converting) but just suggesting that you may be darned if you do and darned (better or worse) if you don't. In any case, IT'S COMPLICATED.
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Old 12-12-2010, 12:04 AM   #10
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One suggestion is to do an estimate of what might happen if you DON'T convert now. i.e., at some point, RMDs become the controlling "event" and then whatever tax laws at that time will determine you taxes (and effective tax rates). So if you can guesstimate what your total qualified nest egg will become by age 70 and divide by your (gummint estimated) lifetime, you'll get your estimated RMD to play with. Not making a suggestion one way or another as far as converting (or not converting) but just suggesting that you may be darned if you do and darned (better or worse) if you don't. In any case, IT'S COMPLICATED.
and compare the above result w/ what you would pay if a did a Roth conversion of some amount today (not necessarily the whole thing.....you could covert smaller pieces for a number of yrs until RMDs start).

and for the result Koolau suggested, perhaps you can use the present day value of your qualified nest egg.........since tax brackets supposedly grow w/ inflation, perhaps that will take care of the growth automatically.
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Old 12-12-2010, 10:15 AM   #11
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The $34K limit is after deductions and credits. Standard deduction in 2010 is $5700 ($11400 if married, 2010 numbers). If you itemize it could be more. Don't forget to use this when pushing to the top of the 15% bracket.
Don't forget the amount for personal exemptions, $3650 per person. For a couple filing Married Filing Jointly with no dependents that makes the first $18,700 not taxed.
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Old 12-17-2010, 11:51 AM   #12
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Thanks to Running Man I think that I finally have a basic knowledge of Roth Ira conversions . The problem is I have a pension & SS survivor benefit which gets me to the 34K limit but my IRA is growing and by the time I need to do RMD's (7 years ) it will be huge . Would it be smarter of me to take small distributions now just to keep it at a manageable amount ?
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Old 12-17-2010, 12:37 PM   #13
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Thanks to Running Man I think that I finally have a basic knowledge of Roth Ira conversions . The problem is I have a pension & SS survivor benefit which gets me to the 34K limit but my IRA is growing and by the time I need to do RMD's (7 years ) it will be huge . Would it be smarter of me to take small distributions now just to keep it at a manageable amount ?
When you become elegible for your own SS, will you continue with the survivor benefit or will your own be larger?

I am on the way out the door right now to see my broker about this- but it seems to me that your taxable income can only grow, and anything over your current baseline will always be taxed at =>25%.

Ha
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Old 12-17-2010, 02:06 PM   #14
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When you becme elegible for your own SS, will you continue with the survivor benefit or will your own be larger?

I am on the way out the door right now to see my broker about this- but it seems to me that your taxable income can only grow, and anything over your current baseline will always be taxed at 25%.

Ha

My SS will be double the survivor amount .
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Old 12-17-2010, 02:54 PM   #15
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Thanks to Running Man I think that I finally have a basic knowledge of Roth Ira conversions . The problem is I have a pension & SS survivor benefit which gets me to the 34K limit but my IRA is growing and by the time I need to do RMD's (7 years ) it will be huge . Would it be smarter of me to take small distributions now just to keep it at a manageable amount ?
it will depend on the actual numbers (SS income, RMDs, pension, etc.) but if with the income you are currently getting (that wont go down over the years), you are in the 25% tax bracket, the smart play may be to fill the 25% tax bracket with roth conversions (while that tax bracket remains at 25%) in an effort to knock down future RMDs. i am thinking tax brackets can only go up from here
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