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Roth Conversions - - Recharacterization
Old 09-02-2016, 11:07 AM   #1
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Roth Conversions - - Recharacterization

I’ve seen multiple posts on this forum about Roth Conversions and I want to add something to the mix.

One thing we should all consider when doing Roth Conversions is something call recharacterization! My first thought when I heard that was “what the heck are you talking about?”

Recharacterization is basically a way to tell your broker to tell the IRS “never mind”, I really didn’t want to make that conversion. Let me give you an example:

You convert $10,000 each of ABC, XYZ, and OOPS for a total of $30,000. ABC goes up 20% from the time you convert it until the end of the year (yes you can extend that time until April 15 and later), XYZ goes up 3%, and OOPS drops 5%. The new values are $12,000, $10,300, and $9,500.

Do you really want to lose $500 of after tax money? Wouldn’t you rather lose $500 of taxable money which will then reduce your taxes? If done properly, that is exactly what recharacterization is all about. The IRS allows you to recharacterize, undo, part or all of each symbol you converted. The problem is that the reconverted value is based on the overall gain or loss of the entire account, not each symbol.

Bare with me here, this is worth money to you! The trick is to open a new Roth account at your broker for each symbol you convert so that the gain or loss is symbol by symbol, not the total of all. Can’t speak for all brokers, but at Fidelity it takes less than 30 seconds to say open a new account, type equals Roth, open, confirm, modify account, change name from Roth to Roth ABC. Then do the conversion of that symbol to that account. Here is why that is valuable.

The total value of the 3 symbols we are using in this post is now $31,800. That is an overall gain of $1,800 on the $30,000 conversion or 6%. If you used a single account and wanted to “undo” the $10,000 of OOPS that you converted, it would cost you 106% of the value of the symbol at conversion time, 106% of $10,000 is $10,600 so the new value of the Roth account would be $31,800 minus $10,600 for a new total of $21,200.

If OOPS was in its own account, the total value of that single account would be $9,500, an overall loss of $500 of the original $10,000, a 5% loss! Undoing the OOPS account would cost you 95% of the value of the symbol at conversion time, 95% of $10,000 is $9,500, the OOPS account is now worth zero! The ABC and XYZ accounts are $12,000 plus $10,300 for a total of $22,300.

It does not matter if you paid $10,600 or $9,500 of your Roth money to undo the OOPS conversion, the value of OOPS in your Traditional IRA will be the same $9,500, as if you never converted it. Only the undo cost changed!

Bottom line: you just saved $1,100!

Another advantage of this method is:

Keep the best and undo the rest

To stay in the tax bracket that you want, you can convert $22,500 of Traditional IRA to Roth. So, you convert $41,275 with each symbol going into its own account. Before you file your taxes, I do mine in December, you make a list of the Rates Of Returns for each symbol. Sort the list by ROR, keep the conversions at the best RORs and undo the rest so you don’t go over your original target amount.

Hope this is helpful to those thinking about doing conversions.
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Old 09-02-2016, 11:19 AM   #2
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The strategy you describe is well-known and used by many on this forum, but a reminder is nice to have. Personally, to me it is more bother than it is worth but I can see where it might have more kick for those who trade individual stocks (I am an indexer).

The other good use of recharacterizations is to optimize use of your favorite tax bracket. For example, I want to do as much Roth conversion as I can up to the top of the 15% tax bracket. In December, I do a proforma tax return based on everything I know about and calculate my conversion amount to the top of the 15% tax bracket and convert a bit more. When I prepare my return I then know how much I could convert and I just recharacterize the excess and reflect the recharacterization in that return... so for the last two years the taxable income on our filed return has been exactly equal to the top of the 15% tax bracket.
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Old 09-02-2016, 11:44 AM   #3
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I had to recharacterize a Roth contribution to a traditional IRA contribution once.

In my case it was more effort than just "telling the IRS never mind".

It actually involved reportable transactions that needed to be recognized, writing a required statement to the IRS and a whole lot of time reading IRS documentation trying to figure out what type of recharacterization applied to my transaction (which was less common) and what needed to be done.

I got a bad taste in my mouth for recharacterizations after this.

It would be good to know if recharacterizing a Roth conversion is a simpler process or not.

Thanks for the write up. It may shed some more light on this.

-gauss
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Old 09-02-2016, 11:46 AM   #4
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Thanks OP I never knew this. A bit of a hassle, but probably worth it for individual stocks.
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Old 09-02-2016, 11:47 AM   #5
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Britain dropped out of the European late on Thursday in June. The market dropped like a rock on Friday and Monday. I did some major conversions on both days and my current RORs are from 1.72% for SVAAX up to 24.86% for FSELX. If my target was 15% and I could go over that target with individual returns considerably above 10% level, it would be something I would consider.

I am currently retired and on Social Security, so my 15% bracket is actually 27.75% when I include the 85% taxability of my SS benefits. It jumps to 46.25% for a short time if I cross into the 25% federal bracket, but then returns to the actual 25% bracket once a full 85% of my benefits have been taxed. I will be doing a lot of calculations this December!


My goal is to avoid any possibility of the 46.25% bracket once my MRDs start.
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Old 09-02-2016, 11:52 AM   #6
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My goal is to avoid any possibility of the 46.25% bracket once my MRDs start.
Amen to that.

I am trying to finish all of my conversions before reaching age 70 and starting SS, thus avoiding the "Tax Torpedo". I have a little under 20 years to do this but basically need to max out the 25% bracket to accomplish this.

Good problem to have.

-gauss
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Old 09-02-2016, 12:05 PM   #7
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....I am currently retired and on Social Security, so my 15% bracket is actually 27.75% when I include the 85% taxability of my SS benefits. ....
I've never heard of anyone calculating a tax bracket that way. Why do you do it and what is the calculation? Example?
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Old 09-02-2016, 12:59 PM   #8
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Originally Posted by pb4uski View Post
I've never heard of anyone calculating a tax bracket that way. Why do you do it and what is the calculation? Example?
The calculations are very straight forward. When you take an additional $100 out of your IRA while retired, it increases the “basis” for the deferred taxability of your Social Security benefits by $100 which makes $85 of your previously tax deferred benefit suddenly taxable. In other words, your adjusted gross income and therefore your taxable income increases by $185. 15% of $185 is $27.75 and $27.75 is 27.75% of the $100 that you just took out of your IRA. Most people call this your marginal tax rate. How much will your taxes increase for every dollar of additional income?

The 46.25% marginal bracket is 25% of $185.

I have to add one more item to this list! Your long term capital gains and qualified dividends are also tax deferred. You pay no tax on them until the combination of your other taxable income plus your gains and dividends push those gains and dividends into the 25% bracket at which time they are taxed at 15%.

Aren’t you just so happy that our tax laws are so simple to follow?

So, that said, here is the really big kicker! You take $100 out of your IRA at the top of the 15% bracket which makes $100 of your gains also taxable at the 15% bracket. This increases the basis for the taxation of your SS benefits by $200 and 85% of that is $170. So, your taxable income goes up $200 plus $170 and 15% of $370 is $55.50! Your marginal tax rate is 55.5%!
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Old 09-02-2016, 01:28 PM   #9
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Convert Early - Convert Often.
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Old 09-02-2016, 01:35 PM   #10
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I don't think that you have it right.

Let's say that you are 63, MFJ and receive $20k a year in dividends and $40k a year in SS. Your tax would be zero so your tax rate is zero on that $60k of income before doing any Roth conversions. Now if you add to that $38k of Roth conversions then you pay ~$7k in tax so your marginal tax rate on that $38k conversion is only 18%, all things considered... not 27.75%

In the scenario, your income went up $68k when you added the Roth conversion..$38 from the Roth conversion and $30k from increased taxable SS (from $4k taxable to $34k taxable SS), but $20k of that was sheltered by deductions and exemptions, some was subject to the 10% tax rate and the rest was subject to the 15% tax rate... but blended together it is only 18%.

In computing marginal tax rates you need to focus on the change in tax divided by the change in income (in this case, the Roth conversion).

For another example... same scenario as above but no dividend income. Tax on $40k of SS would be zero. Add a $58k Roth conversion and you pay ~$10k in tax, a marginal tax rate of 17%... much lower than 27.75%.

Feel better?
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Old 09-02-2016, 02:09 PM   #11
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You seem to be talking about overall taxation, not marginal tax rates. My concern is not the the first $50,000 only cost you $1,000 in taxes “so far”, but that if you take another $1,000 out of your IRA how much do your taxes go up.

I just ran this on TaxCaster. I said I was single, age 66, with no deductions and my income came from investments and other income. With $30,000 from Social Security and $6,000 from Qualified Dividends, I entered $27,500 as my IRA withdraw and was told my taxes would be $4,564. When I increased my IRA withdraw to $28,500 my taxes due went up to $5,120. That was a $556 tax increase due to an additional $1,000 of IRA income. Not sure why TurboTax TaxCaster says the marginal rate is 55.6% and my calculations say 55.5%, THEY obviously have a rounding error!
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Old 09-02-2016, 03:31 PM   #12
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Even if the marginal tax rate on the last $1,000 is high, the fact remains that the tax cost of the Roth conversion is 16.6% on $27,500 or 18.0% on $28,500.

Given that you probably saved 25% or more when you deferred that income, still a good deal.

Interesting thing... I don't like the new Taxcaster so I did it on the old Taxcaster and TaxAct's calculator and H&R Block's tax calculator and they all had only a $277 tax increase (15% on the $1,850 increase in income) so I'm not sure the new Taxcaster is right but it does come up with the numbers that you quoted.
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Old 09-02-2016, 04:12 PM   #13
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Sorry pb, but I have to totally disagree with that logic. Only looking at overall tax rates can lead to disaster.

You are living on a retirement budget and your overall tax rate, Federal, Start, and Local is about 20%. Your friends say lets go on a cruise in February and you know that it will cost you about $6,000 so you cash in $7,500 of your IRA, hold back $1,500 for taxes and have a great time. The reality is that your budget puts you up against the 46.25% marginal federal bracket plus you have to pay 5.25% State and 1.5% local for a total of 53%. You should have taken $12,766 out of your IRA to enjoy the cruise and pay the extra income taxes.

The problem is that there is no great way for you to see how much tax the next dollar will cost you!
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Old 09-02-2016, 04:39 PM   #14
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Well, then we can agree to disagree.

Sorry, but I thought the topic was Roth conversions... if it still is then I think the aggregate tax on the amount converted is relevant to the decision to convert. The marginal tax rate on the last dollar is relevant to the decision on when to stop. I stop at the top of the 15% tax bracket and my effective tax rate (both federal and state) is about 13% of the amount converted (some of it is 0% because it is offset by deductions and exemptions, some is at 10% and some is at 15%) and much more than I saved when I deferred that income.

The last $1,000 I convert cost me 22% in federal and state income tax. If I convert $1,000 more, it costs me 37% in federal and state tax and I'm not willing to pay 37% so I stop at the top of the 15% tax bracket.
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Old 09-02-2016, 05:34 PM   #15
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I don't like the new Taxcaster so I did it on the old Taxcaster......
I don't like the new one either. How did you get to the old one?
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Old 09-02-2016, 05:45 PM   #16
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https://turbotax.intuit.com/tax-tool...ml5/index.html

Only problem is it is for 2013.
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Old 09-02-2016, 05:55 PM   #17
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The topic is Roth Conversions, but tax brackets are extremely important when doing the conversions and also for the reason for doing the conversions in the first place. They are the primary item in determining if a conversion is worth while.

If your combined tax bracket is, for the sake of argument, exactly 33.33% and you convert $30,000 from IRA to Roth and pay the taxes from the converted investments, you end up with $20,000 in the Roth account. If not you still have $30,000 in the IRA. Assuming that your investments double by the time you need the money, the IRA would be $60,000 and if your tax rate was the same you would get $40,000 after tax, the exact same amount that would be in the doubled Roth.

Profit from a conversion comes from the difference between the marginal tax rates when you do the conversion vs when you would have needed the money. If you can do a conversion at a 25% federal level and avoid the 27.75% marginal retirement level it is worth a small amount. If you are avoiding the 46.25% marginal level your savings a huge.

On the other hand if you paid 25% federal plus 7.5% state to do the conversion and then moved to a tax free state during retirement, the 27.75% marginal bracket would result in a loss.

The reason that most people set the top of the 15% bracket as a limit for doing conversions is exactly what I just said. Marginal bracket in vs marginal bracket out is what determines profit or loss.
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Old 09-02-2016, 06:12 PM   #18
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For most of us we can enjoy a relatively low tax rate from ER until pensions and SS start and that is the time to make the most of low cost Roth conversions.

I would argue that the profit of doing Roth conversions is excess of the tax avoided when the income was deferred and the tax paid upon conversion... obviously, if you can reduce the tax paid on conversion through timing then you can increase the profit.

For me, I probably avoided 28% or more on what I deferred, until my pension and SS start I can convert at ~10%.... if I convert or take distributions after pensions and SS start then I'll be paying 25%... still a "profit" but a much lower profit. SS taxability not an issue in that I'm not old enough to start SS yet.

18% is better than 3%.
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Old 09-03-2016, 04:52 AM   #19
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Part of my conversations on this forum come from the situation that my GF is in. She is a widow and plans to retire at 62 when she will receive 81% of her late husband’s PIA, Survivor Benefits. She can then wait until she is 70 to start her own benefits at 129.33% of her PIA.

If you assume that both PIAs were the same, going from 81% to 129.33% is almost a 60% increase in benefits. If she starts out at $20,000 at 62, it would jump to $32,000 at age 70, and that does not include COLA adjustment.

So, our plans for her retirement have to include both low and high benefits levels.

The illustration at the end of this post shows a great example of how the size of your SS benefit completely changes your marginal tax brackets during retirement. In both graphs:
The red shows the normal tax bracket line with no LTCG or SS.
The blue line shows the marginal tax brackets when both LTCG and SS are included.
Ordinary income was played with so that the orange tick mark is at the start of the high tax brackets.
The dotted green line shows the 50% and 85% SS taxability levels.
The dotted red line shows the standard federal tax brackets before they are marginally raised by SS and LTCG taxability.

The table in the middle gives you a picture of what is happening. As your benefit increases, you are getting more tax free (deferred) income so you start paying taxes later and therefore save more tax dollars in relationship to having all of your income as ordinary income. This also pushes the start of the huge marginal tax brackets (The Hump) to higher income levels. Since you have saved more tax dollars at lower income levels, the size of The Hump has to grow so that you can give more of those saved tax dollars back.

Like the old cliché says, a picture is worth a thousand words, so here is the picture of what I just said!


Everyone should understand that when individuals answer questions on forums like this, they are more likely to answer those questions based on their personal perspective of their personal retirement situation. Hopefully this illustration has shown how that perspective can change drastically based on the size of your SS benefits.
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