Roth Conversion Question

[yakers]

I am retired and definitely over age 59.5, I have had a Roth for over 10 years. If I convert some traditional IRA money into the Roth (paying income tax on it) do I have a 5 year waiting period beofre I can withdraw ANY funds from the Roth or only the amount converted? Since the funds are comingled how would it be determined what was converted, old contributions and gains? I want to convert a small amount each year, maybe coming to 10% of the value of the Roth but don't want to 'freeze' the Roth for 5 years following wach conversion.

 

[Alan]

The new money will not lock your account for withdrawals of the old money. The brokerage should keep track of the timings of the contributions for you.

You may like to keep things simple and could create a separate account for the conversions so it is easier to keep track.

 

[Cnote325]

I am retired and definitely over age 59.5, I have had a Roth for over 10 years. If I convert some traditional IRA money into the Roth (paying income tax on it) do I have a 5 year waiting period beofre I can withdraw ANY funds from the Roth or only the amount converted? Since the funds are comingled how would it be determined what was converted, old contributions and gains? I want to convert a small amount each year, maybe coming to 10% of the value of the Roth but don't want to 'freeze' the Roth for 5 years following wach conversion.

I don't believe so...you can withdrawal contributions at anytime, just the earning that is subject to the lime and age limits.

Can some one confirm that this still applies after age 59.5?

If you wanted to keep it separated, you could always open up a new Roth account. This is a handy idea being that you then have the option to re-characterize the Roth back to an IRA should the market take a turn for the worse thus avoid paying the tax on the 'pre-paper loss' amount. Then start the cycle again.

 

[Alan]

I don't believe so...you can withdrawal contributions at anytime, just the earning that is subject to the lime and age limits.

Can some one confirm that this still applies after age 59.5?

If you wanted to keep it separated, you could always open up a new Roth account. This is a handy idea being that you then have the option to re-characterize the Roth back to an IRA should the market take a turn for the worse thus avoid paying the tax on the 'pre-paper loss' amount. Then start the cycle again.

The 5 year rule does apply after 59.5 I believe.

Roth IRA 5 year rule. Withdrawals from your Roth IRA will only be classified as qualified distributions if it has been at least 5 years since you first opened and contributed to your Roth IRA, regardless of your age when you opened it. As an example, you can normally make penalty free withdrawals at age 59½, but if you made your first contribution at age 58, you would need to wait until age 63 to withdraw any earnings made on that portion of your contributions.

Order of Roth IRA Distributions

The IRS makes it easier for taxpayers to make penalty free withdrawals from their accounts by the way they assign the order of IRA withdrawals. Again, referring to IRS Publication 590, Roth IRA distributions occur in the following order:

1. Regular contributions.
2. Conversion and rollover contributions, on a first-in first-out basis.
3. Earnings on contributions.

As you can see, regular contributions are the first to be withdrawn, and they can be withdrawn at any time without taxes or penalties. The taxable portion of your withdrawals is held until the end, making it easier for you to make a penalty free withdrawal.

Roth IRA Withdrawal Rules

 

[ronocnikral]

The way I read the rule, as long as your first contribution is at least 5 years old and you are over 59.5, all distributions are qualified. One established IRA account will satisfy the "5 year rule." The IRS doesn't really keep track of your accounts, just your basis (well, you keep track of it), conversions, earnings, etc. Otherwise if the 5 year rule isn't satisfied, Roth ordering rules apply.

So, the OP should be OK if he truly has an established ROTH IRA account for over 5 years. And if they have been making qualified distributions already, doing conversions should not disrupt anything.

This post from Alan S at Fairmark sums it up as follows:

For earnings to be tax free your distribution must be considered a qualified distribution. All of your Roth IRA accounts become qualified after 59.5 if you also have met the 5 year holding period measured from Jan 1st of the first year you made a Roth contribution. That contribution could have been either a regular or conversion contribution. If your first year was prior to 2008, your Roth IRAs are now fully qualified.

Also, from the IRS website, pub 590. You can also see pg 62 under "What are qualified distirubitions" in the 2011 tax year pub 590 (link:http://www.irs.gov/pub/irs-pdf/p590.pdf). Chart below is on pg 63.

 

[ronocnikral]

If you wanted to keep it separated, you could always open up a new Roth account. This is a handy idea being that you then have the option to re-characterize the Roth back to an IRA should the market take a turn for the worse thus avoid paying the tax on the 'pre-paper loss' amount. Then start the cycle again.

Not to derail the thread too much, but what is the value of filing an extension and then re-categorizing back if investments do poorly? You've lost an opportunity to convert at known tax rates and you really don't save anything. Sure, you delay paying taxes for a bit, but you should need to square up in the future and, as in the case of the OP, it won't likely net you any extra after-tax dollars. It seems like a gimmick you brag about at a party (if you find talking about tanking investments bragging) which creates a lot of work with very little gain. Can you help me understand the value of this exercise?

 

[Cnote325]

Of course it all depends on the situation...

But if you convert $10,000 to a Roth and come tax time, said Roth is only worth $7500, you still pay tax on the full $10,000. However, if you re-characterize it back to an IRA, you delay the tax payment again. Then the next day you convert again.....

At some point 'the man' gets paid, but you can decide when and how much in this case.

It does take some work, but for some, it is advantageous.

 

[RunningBum]

Of course it all depends on the situation...

But if you convert $10,000 to a Roth and come tax time, said Roth is only worth $7500, you still pay tax on the full $10,000. However, if you re-characterize it back to an IRA, you delay the tax payment again. Then the next day you convert again.....

At some point 'the man' gets paid, but you can decide when and how much in this case.

It does take some work, but for some, it is advantageous.

Pretty sure you can't convert again the next day. I forget the details of how long you have to wait. It's almost certainly on fairmark.com.

 

[Cnote325]

Yeah it might be 30 days or something...

 

[ronocnikral]

Yeah it might be 30 days or something...

yes, or something...or just to the next calendar year. but, what ever.

it also depends on if you do a full or partial conversion/recharacterization. It also depends on where money goes in the conversion.

Cnote, have you actually done this?

 

[Cnote325]

I converted in 2010, 3 mutual funds to 3 new Roth IRA's, with the intent of re characterizing if the the market plummeted like 2008. In the end, I kept all 3 accounts and have since combined them into one Roth IRA. Being only 34, the holding restrictions should have no effect on me. I dont foresee touching the money for longer than 5 years...

The reason I did 3 separate accounts, is because if you re-characterize, you must re-characterize the entire account.

You could essentially play it like a gamble...convert what ever amount you want, to however many Roth's you want, invest how you want, then come tax time, decide if its worth paying the tax bill.

 

[packrat44]

I believe if you recharacterize you can not re-convert to the ROTH in the same year. Example: If you did a $10k conversion early in the year and the value fell to $5k later in the year and you rechacterized you could not turn around and re-convert back into a ROTH in the same year. However, when you have recharacterized your conversion you could then do a conversion for DW (or the reverse). By alternating between yourself and your spouse on who does the conversion each year, you allow an option of a "do over" later in the year if the value of your original conversion drops.

 

[MBAustin]

The way I read the rule, as long as your first contribution is at least 5 years old and you are over 59.5, all distributions are qualified. ...

Thanks for clarifying this and posting the IRS chart. I have just started doing ROTH conversions now that our income is lower and realized I should have started with one of DH's instead of one of mine since he is already 59.5. (I decided for simplicity to convert $$ from only one of us each year, alternating each year.) Fortunately, we have no plans or need to access those $$ for a long time, so it's not material to us - but could be for others.

 

[ronocnikral]

The reason I did 3 separate accounts, is because if you re-characterize, you must re-characterize the entire account.

This isn't true either. You can convert into an existing roth and recharacterize the same portion back out. But, you must consider the performance of the entire account, not just the portion you originally converted.

I believe if you recharacterize you can not re-convert to the ROTH in the same year. Example: If you did a $10k conversion early in the year and the value fell to $5k later in the year and you rechacterized you could not turn around and re-convert back into a ROTH in the same year. However, when you have recharacterized your conversion you could then do a conversion for DW (or the reverse). By alternating between yourself and your spouse on who does the conversion each year, you allow an option of a "do over" later in the year if the value of your original conversion drops.

Correct, with a couple of caveats. You can't recharacterize on Dec 31st and then convert back to Roth on Jan 1. You have to wait at least 30 days as well. Also, if you do portions of accounts, you can use that to your advantage. Example, $30k in TIRA1, convert $10k to RIRA, recharact back to TIRA2 (preferably a new account) and then use same amount of recharac from TIRA1 to convert to ROTH next day.

After all this, I stand by statement that this is hardly worth the effort. Unless you are converting huge amounts. Especially with little to no effect on your future after tax dollars. I have no plan to convert huge amounts, but just additional amounts up to the next bracket in retirement. Also, if one's intent is to avoid being tossed into RMD's through conversion, what sense does it make to recharacterize?

 

[Cnote325]

This isn't true either. You can convert into an existing roth and recharacterize the same portion back out. But, you must consider the performance of the entire account, not just the portion you originally converted.


Whoops, meant whole amount not account. That's why its best to break up large conversions to multiple accounts.

 

[kaneohe]

This isn't true either. You can convert into an existing roth and recharacterize the same portion back out. But, you must consider the performance of the entire account, not just the portion you originally converted.


Whoops, meant whole amount not account. That's why its best to break up large conversions to multiple accounts.

Not sure what you mean by the first sentence ............you can convert xx$
and recharacterize any portion of that up to the full amount. Sometimes multiple accounts are suggested so that you can pick and choose what to recharacterize based on performance of different securities.....bad ones go and good ones stay.

 

[ronocnikral]

Not sure what you mean by the first sentence ............you can convert xx$
and recharacterize any portion of that up to the full amount. Sometimes multiple accounts are suggested so that you can pick and choose what to recharacterize based on performance of different securities.....bad ones go and good ones stay.

Example: You convert $10k to an existing RIRA account with $20k already in the account. RIRA has multiple investments, but you stick the $10k in security xyz. You find security xyz's martket value has declined to $5k. You find the market value of the entire RIRA on the day of recharacterization to still be $35k. You do worksheet 1-3 on pg 29 of pub 590 to find you have to recharacterize $5714 to "undo" the initial $10k conversion. That means, $714 of already taxed money will be moved back into the TIRA and you will have to pay taxes on it again.

If the opposite of this happens, your conversion amount holds value and your previous amount in the account decreases, it can work for you.

I apologize if I wasn't clear earlier.

It does seem simpler to just open new accounts and roll them over once your trickeration is over with. If you call that simple.

Further reading...Recharacterization Blues

 

[kaneohe]

Thanks, ronocnikral..........actually I was questioning Cnote's comments.
Yours have generally been accurate so no problem there.

but while you're on the line......you were questioning recharacterizing if the
conversion tanked? I've never done it myself but seems like it could be worthwhile even if the amounts weren't massive. As Cnote mentioned
if you converted 10K and it slumped to 7.5K.....if you recharacterize that,
instead of paying tax on 10K @ e.g. 15% = 1.5K, you convert from another
TIRA 7.5K @ 15%= 1.025K so you save 0.475K. Whether that's worth it or not is a personal matter but it's not trivial. Correct me if I'm wrong but I think you only have to wait to reconvert if you're converting the same assets?
......so if you do it from a different account, you don't have to wait?

 

[ronocnikral]

So, what do you do with the "Savings"? Numbers aside, if you view your portfolio as a long term investment which will appreciate over time, then this is simply paying attention to short term "noise." I'm still in the accumulation phase, so my concern is I do what you say above (except, instead of "re-converting" the $7.5k, I "re-convert" the $10k - I have the money to cover taxes on $10k and I have simply delayed that a year). So, the real "gain" is any interest on the amount of taxes for 1 year. And if you file an extension, you still pay the taxes as of April 15th, and I assume you settle up at the end of the extension, so 6 months later. So, maybe not even a full year.

But, to get tax free dollars later when distributions are being made, I still need to pay taxes on the recharacterized amount. Which leads us to the classic roth v trad debate, where I would point out that if the tax rate is the same, the after tax dollars are the same (ok, a few caveats if you are talking about non-deductible IRA contributions and what not). also, if you are in the distribution phase and up against RMD's, do you convert up to your next tax bracket, or do you throw it all away because of a loss? I haven't really thought about that one too much,

So, if you exercise what is proposed above to a T, all you are really "gaining" is interest on the tax you would have paid for 6 months. If 6 month CD's start coming up, maybe it would be worth it? Otherwise, it makes for an interesting story around the ol' coffee pot and much more work come tax time.

 

[RunningBum]

It may be noise to you, but if you pay less taxes overall, you will come out better. Being able to recharacterize and they re-convert a lesser amount later results in less taxes. Of course it's better if your Roth IRA account didn't lose money in the first place, but if it does, you have some ability to reduce taxes.

That said, I made pretty much all of the mistakes listed here when I recharacterized a couple years ago. I mistakenly thought I could recharacterize specific stocks and not average out of the whole account, so I didn't get as much out of the recharacterization as I thought I would. Then I tried to re-convert too quickly, but luckily my brokerage caught it and backed it out and sent me a good explanation of why. But, this year I'm finally correctly re-converting, about 10K less than I recharacterized, so I'll come out about $1500 ahead. It's more than interest on the taxes, for sure.

 

[ronocnikral]

RunningBum, it is difficult to gauge what you have done and how much you have really
"saved." I still contend that you may save taxes this year, or the next year or so on...but it is really a deferment and eventually you'll have to pay taxes on that money. But, I have not done this, just thought about it at a high level, so perhaps some hard numbers (either fictitious or real) could help me to understand?

 

[RunningBum]

I'll skip the unimportant complication of the partial recharacterization, and just call it a full conversion. I'm also rounding the numbers but they are very close. I pay taxes on my ROTH conversion with other funds.

In 2010, I converted $30K, and prepared to pay taxes on it. Let's say it was at 15% (even though it was actually 25%, but I don't want to muddy the picture by showing conversion at different rates), so I prepared to pay $4500 in taxes. Later that year, the stocks dropped in value so I recharacterized it before the end of the tax year, so I didn't owe the $4500 in taxes. At this point I have just deferred the taxes because the funds were back in a TIRA that would eventually be taxed.

In 2012, I've re-converted the IRA. It is now at $20K at the time of conversion. Bad investments, but these are very close to the real numbers. So, I'll be paying $3000 in taxes this year at 15%. That's $1500 less than I would've paid in 2010 had I not recharacterized. The money is now in the ROTH IRA so there are no more taxes to pay. Nothing is deferred anymore. I clearly saved $1500 in taxes.

It's certainly true that at $20K, my ROTH IRA is $10K less than before, so I'm actually coming out $8500 behind rather than $1500 ahead. But since I was making the same investment decisions whether the funds were in a TIRA or a ROTH IRA, they would be worth $20K no matter what. Converting, re-characterizing, and re-converting had no effect on that. What it did do was let me soften the blow by paying $1500 less in taxes, so I'm $8500 behind rather than $10,000 behind. There's nothing I could do to retroactively avoid the drop in value from $30K to $20K. But I could retroactively change which amount I paid the conversion tax on.

It wasn't a guaranteed tax savings. Had the funds recovered back to $30K while in the TIRA after the re-characterization, it would've essentially been a wash, and if they had gone above $30K, I'd have paid more taxes. But they didn't.

 

[ronocnikral]

thanks for that! you are correct, it can save you more money when playing with all of the funds. if only doing partials over long periods of time, it seems the benefit wouldn't be as great?

 

[RunningBum]

That's too general of a question to answer absolutely. I don't think there's any strategy to decide whether to convert all or partial based on how recharacterization works. You convert based on whether it makes tax sense over your lifetime to do so (and usually that means partial conversions over time), and you don't plan on losing money once it's in the Roth. But if it does, you consider recharacterizing to get some taxes back. Certainly if you've only converted part, you get less of a tax benefit.

One strategy I've heard of is to convert some amount into a new Roth account, and then make your riskiest investments in that account. If they payoff, you've got a big gain tax-free, since the gain is post-conversion. If they fail, you recharacterize, put the remaining funds in safer investments in your TIRA, and most likely you'll convert a lower amount and pay less taxes later.

 

[kaneohe]

thanks for that! you are correct, it can save you more money when playing with all of the funds. if only doing partials over long periods of time, it seems the benefit wouldn't be as great?

but to the 1st order, isn't the total the sum of the partials? Of course, not all
of the conversions will benefit from recharacterization bc the market will be
up after some of them, rather than down, so maybe you'll only get half the benefit, but that could still be significant.....depending on how much fussing you want to do.

Maybe it's like tax loss harvesting......if you end up selling all the assets eventually, maybe the only gain is the time value of the tax savings and what returns you can get from them. I vaguely recall seeing some claim that TLH can add some fraction of a percent to your returns which on the surface doesn't seem like much but, like the low cost VG index funds, that small amount compounded over time can be significant.