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Roth Conversions at high tax rates
Old 01-30-2011, 09:34 AM   #1
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Roth Conversions at high tax rates

I have ignored Roth conversions because DW and I are in fairly high income tax brackets. I have a substantion pension that is essentially fully taxable and DW has large tax deferred accounts and a $30K taxable income level that will (may) continue for many years into "retirement." I just assumed the immediate tax hit of converting to Roth would not be worthwhile. Our situation is that about 75% of our portfolio is in tax differed accounts (IRAs, 401Ks, Thrift). The rest in after tax. We have no Roths because until the recent changes in law we were at high tax brackets and could not contribute.

I have assumed our best approach to withdrawal would be to draw down our taxed accounts and then switch over to the tax deferred accounts (and higher tax).

But... for the first time I ran ORP and saw that it appears to recommend converting large amounts to a Roth over the next 4 years while essentially exhausting the after tax accounts (to pay taxes and living expenses). It then has us start pulling from the Roth and the tax defferred starting in 5 years and running for the next 16 years, after which the Roth is depleted and we switch over to withdrawals solely from the tax deferred accounts.

This is a fairly radical departure from what I assumed made sense. It certainly throws all the steady 3-4% withdrawal scenarios aside since it counsels larger initial expenditures to pay taxes on big conversions). So far I haven't researched this to any significant degree but I did some quick calculations at a calculator that purports to answer whether you should convert and it, too, at first glance appears to counsel conversion.

I am curious about whether others in heavily deferred situations with large taxable pensions have looked into this. Anyone out there converting major chunks of IRAs/401ks to a Roth while at high tax brackets?
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Old 01-30-2011, 10:33 AM   #2
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Your situation does not apply to us, but I have read many times that folks who will be in top tax brackets throughout retirement might as well take the tax hit sooner rather than later. The idea is that tax-free growth is better than tax-deferred growth when in the high marginal income tax brackets.

When I have to make a decision, I intend to run TurboTax as if I was 65, 70, 75, 80, 85, etc and fill out a spread sheet to confirm or deny any results from ORP.

You might find that the difference between doing it different ways is not very much at all, which would mean that your choice of how to do all this just doesn't matter that much.
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Old 01-30-2011, 10:35 AM   #3
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I am not in your situation either but
it appears to me that the key thing is not what absolute tax rate you convert at, but whether that rate is higher or lower than what it will be when you start withdrawing from the tax deferred account in the future. I believe you can show mathematically that if the rates are the same, the Roth is (somewhat) more beneficial (and not any worse)..........though actually believing takes a bit longer because the qualitative (not quantitative) idea of time value of $$$ gets in the way. One thing to keep in mind...once you start taking RMDs, your bracket may go even higher.

Ex: start with $100K in TIRA and 25K in taxable; 25% bracket
Option A: leave as is. N yrs later, assets double so you have 200K in TIRA and
50K- (a bit less because some taxes have been/will be paid). If you at that point,
convert to a taxable equivalent (or Roth) , you pay 50K in taxes, and have a bit less than 200K left.

Option B: convert now. Use the 25K to convert 100K TIRA to Roth. In N yrs, assets
double and you have 200K in Roth. This is somewhat larger than Option A depending on the taxes paid for the taxable account.

I guess you would not want to convert so much at one time that your bracket increases a lot (the reverse of the RMD issue during withdrawal).
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Old 01-30-2011, 11:31 AM   #4
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Quote:
Originally Posted by donheff View Post
I have ignored Roth conversions because DW and I are in fairly high income tax brackets. I have a substantion pension that is essentially fully taxable and DW has large tax deferred accounts and a $30K taxable income level that will (may) continue for many years into "retirement." I just assumed the immediate tax hit of converting to Roth would not be worthwhile. Our situation is that about 75% of our portfolio is in tax differed accounts (IRAs, 401Ks, Thrift). The rest in after tax. We have no Roths because until the recent changes in law we were at high tax brackets and could not contribute.

I have assumed our best approach to withdrawal would be to draw down our taxed accounts and then switch over to the tax deferred accounts (and higher tax).

But... for the first time I ran ORP and saw that it appears to recommend converting large amounts to a Roth over the next 4 years while essentially exhausting the after tax accounts (to pay taxes and living expenses). It then has us start pulling from the Roth and the tax defferred starting in 5 years and running for the next 16 years, after which the Roth is depleted and we switch over to withdrawals solely from the tax deferred accounts.

This is a fairly radical departure from what I assumed made sense. It certainly throws all the steady 3-4% withdrawal scenarios aside since it counsels larger initial expenditures to pay taxes on big conversions). So far I haven't researched this to any significant degree but I did some quick calculations at a calculator that purports to answer whether you should convert and it, too, at first glance appears to counsel conversion.

I am curious about whether others in heavily deferred situations with large taxable pensions have looked into this. Anyone out there converting major chunks of IRAs/401ks to a Roth while at high tax brackets?
This doesn't make sense. Why convert to Roth but begin withdrawing in 5 years? If you believe your future tax rate to be higher, convert some, then draw down the tax deferred first and leave the Roth to the end. If your future tax rate is lower, keep the tax deferred and convert nothing.

If you have substantial tax deferred income a big chunk of that money is really unpaid tax and interest free loan that you can invest and keep the proceeds. Why give it up now without a compelling reason?
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Old 01-30-2011, 12:46 PM   #5
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Sounds like your pre and post retirement tax rates are going to be about the same. Converting to a Roth now kind of lets you shelter some of you currently taxable funds in the Roth (by paying the taxes for the conversion). The Roth will hold more after-tax value than the original 401k/IRA. And lower RMD's later on may help reduce taxes later on.

Usually the reason for pulling some retirement income from traditional 401k/IRA and some from Roth is to keep taxable income below a relatively nearby tax bracket. You are trying to take the money out of your traditional 401k/IRA at the lowest tax rate while filling any additional income needs with the Roth. Lower 401k/IRA balances may help with this by lowering RMD's.
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Old 01-30-2011, 01:26 PM   #6
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Quote:
Originally Posted by donheff View Post
This is a fairly radical departure from what I assumed made sense. It certainly throws all the steady 3-4% withdrawal scenarios aside since it counsels larger initial expenditures to pay taxes on big conversions). So far I haven't researched this to any significant degree but I did some quick calculations at a calculator that purports to answer whether you should convert and it, too, at first glance appears to counsel conversion.

I am curious about whether others in heavily deferred situations with large taxable pensions have looked into this. Anyone out there converting major chunks of IRAs/401ks to a Roth while at high tax brackets?
Regarding the 3-4% withdrawals: As MichaelB points out, you are simply "recognizing" that your deferred accounts don't fully belong to you. You owe some % to the taxing bodies. So paying taxes isn't really an "expenditure" (like buying a car) it's more like paying off the mortgage early. The house (hopefully) has the same value. The only difference is how much of the house belongs to you and how much to the bank. Here, the question is how much of the IRA belongs to you and how much to the gummint.

I have been converting "major chunks" of TIRA/401(k) money to Roths. My other income is taxable but not at "high tax brackets" since there isn't too much of it. (When I start taking SS - probably at age 70 - that will be a bigger issue.) But, my conversions are pushing me into the 25% (maybe even a little 28% this year) brackets (plus state tax!). I'm willing to do that so that I will have some predictability in future tax years. That's one major reason for my conversions. My calculations suggest that I'll come out even or a little ahead with ROTHs under current tax law. If by some miracle, tax rates go down, i lose. If they go up (hint, hint) I win. Since (I hope) the tax laws are on hold for 2 more years, I'm going to continue converting up to the top of the 25% bracket. I've mentioned before that this is sort of a good problem to have. It means we have enough money that it needs to be managed. I'll gladly take that problem over not having enough to RE.

As always, good luck and YMMV.
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Old 01-30-2011, 02:17 PM   #7
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This doesn't make sense. Why convert to Roth but begin withdrawing in 5 years?
This is how I see it. I have made conversions completely withing the 25% bracket, but none above that.

I will leave that money in the Roth as close to forever as I can.

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Old 01-30-2011, 02:27 PM   #8
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Two other issues: converting Roths to reduce your required minimum distributions down the road, and maximizing Roth balance for estate purposes (tax-free to the beneficiaries).

I can't think of a good reason to draw down Roths second, as using them last is what it says to do in nearly everything I have read. There must be specific circumstances I am overlooking.
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Old 01-30-2011, 03:28 PM   #9
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i-orp claims to optimize/maximize the after-tax amount of $$$ available during retirement(avg lifetime?). Is it possible that it is taking Roth withdrawals in an attempt to hold down the tax rate during that section of life and that there simply weren't enough taxable funds in the beginning to support converting more thus still leaving a large amount of tax-deferred funds as the only survivor in the end?
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Old 01-30-2011, 03:36 PM   #10
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I will have to analyze this pretty carefully. One aspect I worry about is making large additional tax payments (thru higher initial withdrawals) thus drawing down the overall portfolio in the early years if another bear was to arrive in a couple of years. We probably should at least use conversions to max out the bracket we are currently in (it is not the top bracket now but would jump into it with jumbo conversions). I haven't paid much attention to dates either -- do I have until April to make a 2010 conversion?
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Old 01-30-2011, 03:39 PM   #11
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Originally Posted by kaneohe View Post
i-orp claims to optimize/maximize the after-tax amount of $$$ available during retirement(avg lifetime?). Is it possible that it is taking Roth withdrawals in an attempt to hold down the tax rate during that section of life and that there simply weren't enough taxable funds in the beginning to support converting more thus still leaving a large amount of tax-deferred funds as the only survivor in the end?
I guessed that was what i-orp was calculating. Pull down taxed and make conversions first. Then mix tax deferred and Roth to hold down taxes in the mid years.
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Old 01-30-2011, 08:11 PM   #12
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I haven't paid much attention to dates either -- do I have until April to make a 2010 conversion?
I think it was the end of Dec 2010. I recall reading that if you were considering it but weren't sure, to do it before the end of Dec because you could alway undo it later.
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