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Roth IRA Conversion: A Bad Bet?
Old 01-30-2010, 10:21 AM   #1
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Roth IRA Conversion: A Bad Bet?

I've looked at doing a Roth IRA conversion several times over the years and it never makes sense to me. Everybody's financial parameters are different, but here are my fundamental objections:
  • Most of the people in range to retire early are there because they have a substantial income now and live below their means. It makes no sense to me to assume that somebody in that position is likely to have the same or higher tax rate (more or equal income) once they stop working in retirement -- one of the often cited justifications for a Roth.
  • It is general wisdom now that we can expect higher tax rates in the future. But regardless of which party is in control, I doubt they would substantially raise taxes on the middle class. And many of us who live below our means will have a middle class income, though not middle class assets, in our retirement.
  • Doing a Roth conversion now involves spending money on taxes today based on assumptions about what the government will do in the future. A general principle of financial success that I have observed is to defer expenses, and not be pressured by fear into spending money early.
  • Lastly, there is an argument for doing a partial Roth conversion as a tax diversification strategy. There is some sense to that. However for that to really make a difference, a substantial portion of your assets need to be converted, which again boils down to making a big, low-probability bet that your tax bracket will be higher in the future. Additionally it means another account to manage, and thus more complexity, and room for error, in your financial life.
Bottom line for me is that the Roth IRA conversion is a bad bet. What do you think?
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Old 01-30-2010, 10:38 AM   #2
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I have some money in a ROTH. I have not yet decided what to do this year -

1- diversify makes sense to me

2- I realllly don't think tax rates will stay the same or go down.

Putting everything in a ROTH and having a honking big tax bill doesn't make sense to me, but some, yes.

(This also depends on where a person is in a tax bracket. Going substantially into the next bracket with a big chunk of ROTHing wouldn't make sense to me. And then location - I live in tax hell - NYC - so I use a 401k and regular IRA as much as I can)

YMMV

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Old 01-30-2010, 11:12 AM   #3
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I've been ER'd for 7+ years. I did my first Roth conversion in Dec for last tax year to 'top off my tax bracket'. Looking very long term eventually RMD's+SS would probably have put me into next tax bracket. A Roth will give me more flexibility on withdrawal's without worrying about taxes on the money or the earnings. By paying the taxes with after-tax money, I am effectively contributing to a Roth even though we had NO earned income. You can even recharacterize, if the fund loses value <until Oct anyways>. Future interest and gains won't be taxable, but losses not deductible either. I won't ever be in a lower tax bracket than I am in now, so I really don't see the 'bad bet' for me.
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Old 01-30-2010, 12:22 PM   #4
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[QUOTE=JustNtime;898358 RMD's+SS would probably have put me into next tax bracket. A Roth will give me more flexibility on withdrawal's without worrying about taxes on the money or the earnings.[/QUOTE]
I use Fido income planner for forecasting and the RMD values added to my SS and small DB pushes the totals to spending levels well above what we live at now. If you have been an ardent LBYMer, you may be surprised just how much the RMD amounts are. For that reason converting annually to Roth to top of 15% bracket is helping to get my RMDs down to a level that make sense for our expected life style post RMD.
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Old 01-30-2010, 12:27 PM   #5
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Just as I prefer to diversify my investments, I like to diversify my portfolio into all different forms of tax treatment. I figure that will "hedge my bets" and allow me the maximum flexibility to produce the most income with the lowest tax burden.

There are certainly pros and cons. If *nothing* in tax law changes (yeah, right) AND you expect your marginal retirement tax rate to be equal or higher, it probably makes sense. Also, currently Roth income doesn't count for the purposes of taxation of Social Security benefits, which is another plus. Finally, Roths aren't subject to RMDs, so if you don't need to tap the account for income, you won't have to even after age 70 1/2.

I'm fairly sure that even our heroes in Washington wouldn't retroactively *directly* tax Roth withdrawals. I could see them eliminating the Roth concept but I suspect anything already in the Roth accounts would remain tax-free (directly) when withdrawn.

I keep saying "directly" because there are some things that could happen that would make Roth conversion a bad deal. For example, if they significantly cut income taxes and replaced it with a VAT or a "national sales tax," that would cause Roth holders to suffer because it would have been better to avoid income taxes up front than on the back end.

I converted one conventional IRA to a Roth last week. Not because I thought it was the ideal thing to do in our situation, but because I had a nuisance conventional IRA worth $160 with the custodian where I have a larger Roth, and it just simplified things to convert it, consolidate into one acccount and eat the $40 in taxes this year.
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Old 01-30-2010, 12:37 PM   #6
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This is a great idea for a thread

Quote:
Everybody's financial parameters are different
Above and beyond all else, I agree with everyone is different. Even though I think some of the original objections do not hold water, I agree I might not see the same solution to each issue presented.

Quote:
Most of the people in range to retire early are there because they have a substantial income now and live below their means. It makes no sense to me to assume that somebody in that position is likely to have the same or higher tax rate (more or equal income) once they stop working in retirement -- one of the often cited justifications for a Roth.
I will give two examples of higher income needs-
1) removal of deductions while working- my kids and mortgage keep me in 15% tax bracket now, however our gross income is close to 28% tax bracket. If the mortgage were to change to spending (like vacations) our taxes go up on same income.
2) RMDs can change the tax bracket of a person regardless of spending. This was brought up by a previous poster as well.

Quote:
It is general wisdom now that we can expect higher tax rates in the future. But regardless of which party is in control, I doubt they would substantially raise taxes on the middle class. And many of us who live below our means will have a middle class income, though not middle class assets, in our retirement.
I agree with this point to some degree.
I believe there will always be a tiered income tax structure in this country. a 10-15-25-28% tax bracket will always exist, even though those numbers will probably change once every 5-10 years. The ranges of those brackets will change every year as well.

Quote:
Doing a Roth conversion now involves spending money on taxes today based on assumptions about what the government will do in the future. A general principle of financial success that I have observed is to defer expenses, and not be pressured by fear into spending money early.
Two points:
1) Some people while WORKING will know that their tax bracket will change from year to year. Based on a spouse returning to work, getting a raise. changing locations (states) or similar. Converting when tax bracket is at a relative low makes sense.
2) doing gradual conversions was not mentioned by OP, but was mentioned by other people which responded.

Quote:
Lastly, there is an argument for doing a partial Roth conversion as a tax diversification strategy. There is some sense to that. However for that to really make a difference, a substantial portion of your assets need to be converted, which again boils down to making a big, low-probability bet that your tax bracket will be higher in the future. Additionally it means another account to manage, and thus more complexity, and room for error, in your financial life.
The antithesis to this comment is having all your eggs in one (taxable) basket.


I believe there are 3 distinct issues when considering a Roth.
1) taxes (covered above and in other threads ad nauseum)
2) withdraw rules (this is covered, but not given enough credit)
3) inheritance. rarely discussed, I believe a Roth account has more favorable terms when passed on to further generations relative to a traditional IRA. Been a while since I read up on that, but comments to this effect would be appreciated.
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Old 01-30-2010, 01:03 PM   #7
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Thoughts on your bullet points:

Tax rate now versus tax rate in future (assuming stable at current rates):
If making good money now, already in 28% or 33% or 35% bracket. The higher the current bracket the lower the tax cost of the conversion (as long as AMT is avoided -- if not already paying it). Even at 25% bracket, Roth conversions only result in additional 3% or 6% or 8% of balances paid in taxes ONE TIME -- and only on the marginal amounts, not the entire account balance. Then, all future earnings tax free. One year's earnings/yield on IRA balances in a "normal" interest rate or market gains environment would be 6% or better. Even in a "poor" economy with average 2% yield, taxes on conversion would be made up in 2 to 3 years -- then all future earnings tax free.

In future, if you plan on drawing a "middle class" income from savings -- your marginal tax bracket on the savings withdrawals will be 25% or more (at current rates). Social Security will use up most of the lower portion of retirement years' brackets -- 85% of SSA taxed with "adjusted" AGI above $25,000 for individuals and $32,000 for married couples. 401-K and Traditional IRA withdrawals would be included in AGI -- Roth would not -- Roth doesn't trigger taxes on SSA.

Make transfers over several years. Don't have to transfer entire lump sum this year -- despite the guvmint INCENTIVE to dump it all at once (so that they can make revenues NOW). Target conversion amounts to keep AGI within lower marginal rates ("top off tax bracket") -- and avoid an AGI that triggers AMT.

Almost certain that you can count on higher tax rates in future. And, traditionally, middle class has been the one that gets soaked. Various deductions and exemptions get dropped. Latest Bush tax cuts completely exempted first $8,500 from taxes (by expansion of standard deduction and personal exemption amounts) and established a new very low 10% marginal rate on the next $16,000 in AGI (on top of the $8,500). Bush tax cuts will sunset in 2011 -- and Democratic leaders (Pelosi and Reid and others) have indicated that most will NOT be renewed. Lowest rate will be 15%, and brackets will shift down -- no new taxes need to be passed -- just reinstatement of the old ones by lack of action. Also, several other exemptions and deductions will disappear. In future years, taxes will have to be increased to cover the existing entitlement programs (social security, Medicare, Medicaid) -- even before the MAJOR expansions currently being considered.

Wait until you are ready to retire to make the conversions. Move to a state with no income tax (even if only for a year or so) to do the conversions.

Potential Drawbacks:

Congress rescinds the Roth: Pelosi and several other leading Democrats have proposed this. Proposal is to simply make all future earnings taxable going forward. No taxes on original contributions because these were already taxed. Congress would "give" any past earnings to the taxpayer -- no taxes on prior earnings -- Gosh! How generous!

Asset protection issue: Roth IRA's currently protected with other IRA's in bankruptcy, and protected from judgments in many states. If Congress removed the IRA status for Roth's, would they be protected from bankruptcy and judgments?

Asset protection issue: Although Roth's are protected under federal bankruptcy code, a significant number of states do not provide protection from creditor judgments for Roth IRA's, but do for Traditional IRA's. Also, money left in a 401-K is the most protected from bankruptcy and judgments by ERISA.
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Old 01-30-2010, 01:23 PM   #8
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This subject is rapidly assuming the same status as the "Pay off my mortgage or invest the money?" threads.

Since newer posters don't seem to bother reading the E-R.org FAQ Archives, maybe this change of pace will pique some interest:
Roth IRA conversion - Bogleheads

Quote:
Originally Posted by headingout View Post
[*]Most of the people in range to retire early are there because they have a substantial income now and live below their means. It makes no sense to me to assume that somebody in that position is likely to have the same or higher tax rate (more or equal income) once they stop working in retirement -- one of the often cited justifications for a Roth.
I'm not sure what "makes no sense" to you. A conventional IRA's required minimum withdrawals may jump ERs into the 25% bracket with no other action. A substantial majority of ERs will someday receive Social Security, which also could boost their AGI from the 15% bracket to the 25% bracket if they're already near the top of the 15% bracket.

A number of ERs are also contemplating additional income later in retirement from either their own later pensions or their spouse's. Spouse traded in her big active-duty paychecks when she was 39 years old for a pension that won't kick in until she's 60.

As for the rest of your points, here's a different set of viewpoints. Neither one of us is necessarily wrong, but I'm not the one defending my actions by impugning the actions of others:
Quote:
Originally Posted by headingout View Post
[*]It is general wisdom now that we can expect higher tax rates in the future. But regardless of which party is in control, I doubt they would substantially raise taxes on the middle class. And many of us who live below our means will have a middle class income, though not middle class assets, in our retirement.
I can't tell you which way this one will go, either. But Bud Hebeler's long-term perspective is that middle-class tax rates aren't going to get any lower, either.
AnalyzeNow, Retirement Planning

I agree that political risk is a minor reason for a Roth IRA conversion.

Quote:
Originally Posted by headingout View Post
[*]Doing a Roth conversion now involves spending money on taxes today based on assumptions about what the government will do in the future. A general principle of financial success that I have observed is to defer expenses, and not be pressured by fear into spending money early.
Another principle of financial success would be to spend money now in anticipation of future compounded savings. Some would even go so far as to claim that deferred expenses can be more costly than well-planned capital expenses or maintenance. But this analogy is pretty easy to torture.

Quote:
Originally Posted by headingout View Post
[*]Lastly, there is an argument for doing a partial Roth conversion as a tax diversification strategy. There is some sense to that. However for that to really make a difference, a substantial portion of your assets need to be converted, which again boils down to making a big, low-probability bet that your tax bracket will be higher in the future. Additionally it means another account to manage, and thus more complexity, and room for error, in your financial life.
Fidelity, among other financial service companies, keeps an eye on IRA requirements-- even to the point of nagging about contributions, RMDs, or other deadlines. I think this will improve in coming years.

Solely on this consideration, Roth IRAs seem simpler than conventional IRAs. I'd rather have a Roth IRA that never needs an RMD than to have to deal with a conventional IRA. But I agree that this is a minor consideration.

Quote:
Originally Posted by headingout View Post
Bottom line for me is that the Roth IRA conversion is a bad bet. What do you think?
I think everyone has to do their own math for their own situations, while considering that the situations can change every year up until RMDs. And the more that the math leads to a straightforward algebraic result than an estimate of probabilities, then the less of a "bet" it becomes... let alone a "bad bet".
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Old 01-30-2010, 01:35 PM   #9
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I think folks here have pretty much covered the cons and most of the pros. Unless I missed it, though, there is a pro which wasn't covered - sorry if I missed it.

Example: If you convert a trad. IRA of $1000 to a Roth of $1000 AND pay the taxes due out of other funds you have laying around, you step up the value of your IRA by the amount of the taxes. IOW, a $1000 trad. IRA is only worth about $750 if you are in the 25% tax bracket. In essence, paying the tax now allows $1000 to work for you tax free. It's like being able to make a "stealth" contribution to your IRA.

Naturally, and as always, YMMV. Do what is BEST for your own situation. Get help from a numbers person if you need to. Good luck.

Good luck!
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Old 01-30-2010, 02:58 PM   #10
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"Example: If you convert a trad. IRA of $1000 to a Roth of $1000 AND pay the taxes due out of other funds you have laying around, you step up the value of your IRA by the amount of the taxes. IOW, a $1000 trad. IRA is only worth about $750 if you are in the 25% tax bracket. In essence, paying the tax now allows $1000 to work for you tax free. It's like being able to make a "stealth" contribution to your IRA. "

hmm...I hadn't thought of a Roth conversion like this, but the concept is interesting. Something to think about...
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Old 01-30-2010, 04:42 PM   #11
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I agree with Koolau. It's analogous to deciding whether to put $5k into roth or traditional IRA. Even if your taxes will be the same in the future as today, roth will have the benefit due to more (after-tax) money getting the tax benefit. (E.g. see example at the end of http://en.wikipedia.org/wiki/401%28k%29_IRA_matrix)
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Old 01-30-2010, 05:42 PM   #12
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The Fidelity conversion tool let me see the effects Koolau describes. Even if tax rates are the same from work through retirement you can shelter more dollars in a Roth than a traditional IRA. That favors the Roth a little bit.

As an early retiree, I'll have several years of no income, no SS, no pension, no traditional 401k/IRA withdrawals, if I can convince DW it's OK to stop working. That's when I'll convert, up to the top of my expected retirement tax bracket. When the other income starts, I'll allow retirement income to fill up that lower bracket and then fill in with Roth withdrawals as needed. I think in 20 or 25 years the RMD's finally catch up with me and I'll nudge into a higher tax bracket again. So maybe I'll be converting a little this year. The longer DW keeps working, the more I should be converting, according to my calculations, since we will be back to our current tax bracket earlier in retirement.
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Old 01-31-2010, 07:00 PM   #13
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Historical income tax rates are available here:
The Tax Foundation - U.S. Federal Individual Income Tax Rates History, 1913-2010

fwiw I'm in my early 30's and think it will be very unlikely for my tax rate at retirement to be as low as it is now, so I'm planning to convert aggressively this year. Some of the pre-1980s tax rates were pretty scary.
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Old 01-31-2010, 09:22 PM   #14
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Let me recommend this post by Maurice

2010 IRA conversion - here's a formula to help you decide

This convinced me to go for it, at least to the top of my 25% bracket and maybe into 28% too. I kept it to 25% for 09, (actually a little below to avoid tripping extra Medicare premium), but so far haven't decided how much to convert in 2010.

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Old 02-01-2010, 12:39 PM   #15
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Thanks for posting this thread. My initial strategy was to keep everything in tax deferred accounts as much as possible (ie traditional 401k and traditional IRA). I think I need to consider whether it makes sense to divert part of the 401k and IRA money into Roth 401k's or Roth IRA's, and/or consider IRA conversions.

My thinking was along the lines of OP. Our income in ER will be much lower than our current income. We are in 15% bracket now, but that is due to funneling around $40,000 a year into 401k's, IRAs, and HSA. We have a little room to spare in the 15% bracket. State tax is 7%, and would be assessed on all Roth contributions. The future could include a relocation to a jurisdiction that doesn't have state income tax (unlikely we move just for the tax benefits though).

My thinking was that we would still be in the 15% bracket in ER, or less. So many tax unknowns make it hard to know what the optimal strategy is. If dividends and cap gains retain favorable tax treatment, then we could potentially avoid most federal tax by using a combination of selling appreciated assets and paying CG tax, taking dividends from our taxable holdings, withdrawing from Trad IRA/401k, and taking a little from Roth's. Right now the Roth balances are tiny (only 5-10 percent of the total portfolio), so it may make sense to increase those balances some. It just hurts to pay thousands in tax now that I MAY be able to defer for a long time and somehow avoid completely depending on withdrawal strategies and future tax rules.

Somehow I see the lower middle class income I'll be living off of as populistly favorable. Should be able to show a taxable income around $35000-40000. "Poor".
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Old 02-01-2010, 05:39 PM   #16
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Thanks for posting that document of historical income tax rates - it's hard to imagine there having been a 94% tax bracket at one point! That would put a damper on my motivation to earn more.

One point I haven't seen in this thread but has been brought up before: for soon-to-be very early retirees who may have 20+ years to go before SS kicks in: once you ER, any IRA withdrawals/conversions will be more likely to fall into the lower tax brackets before reaching your marginal tax rate. So even if you wind up in the same marginal bracket after retirement, you'll wind up paying a lower effective tax rate on a conversion compared to the present day when it would all be taxed at your marginal rate. To me this is a strong argument for waiting to do Roth conversions until your income is lower than usual (presumably after ER when you no longer rake in the big bucks which you're using to save for ER).

The other Roth advantages (tax diversification, no RMDs, inheritance rules, likely higher future tas rates, etc) may offset this disadvantage for your personal situation, of course.
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Old 09-07-2010, 11:46 PM   #17
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If you put all that aside and think for the long term, you can grow your Roth IRA assets huge with the power of compounding interest.... And yes, even though Obama is opposed to middle class taxation and wants to cut their taxes, that is not really happening is it? And whoever becomes President after Obama will definitely not be so thinkful of the middle class, thus taxes are sure to go higher in America in the future. Here are the basics of compounding interest

With Roth IRAís you can deposit up to $4,000 per tax year. (5k starting in 2008 ) You donít have to put in that much, it could be $25 a month or $100 a month, whatever you can afford. You put it in with after-tax dollars and it grows tax-free. So that when you pull the money out when youíre 59 1/2 (or later) you donít owe capital gains taxes on all the interest youíve earned. Any other regular investments you do have to pay taxes say, if you have stocks/investments outside of a Roth IRA account.


To illustrate:
John* starts putting $100 a month in his Roth at age 25 until heís 65. When he retires heíll have $1,100,000. (assuming compound interest around 8%)
Bob doesnít start putting money in his Roth until heís 35. He then puts the same $100 every month until he reaches 65. When he retires heíll only have $300,000!!!
Those 10 years of not investing cost him $700,000 OMG!!
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Old 09-08-2010, 03:35 PM   #18
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This is a great thread. I have never been able to contribute to a Roth...so also investigated doing so this year with the tax changes. I probably will not do it because:
1. In order to do so, the amount of money I convert is calculated as a percentage of all "deferred money" which makes my tax bill higher this year than I would like. Originally had started a non-deductible IRA specifically for this purpose several years ago...thinking I could simply convert that and only have to pay tax on that amount of money as some articles last year originally indicated. In fact one guy in the Wall Street Journal wrote" Converting a nondeductible IRA is a no-brainer". He was wrong.
2. I still will not be able to "contribute" to the Roth in the next few years for while the rules for income limits for "converting" have changed, the rules for contributions have not. I would have to continue to contribute to a regular IRA and then convert each year. In 2013, when I ER and income is reduced, I may be able to contribute to a Roth anyway.
3. My taxes in retirement will go down significantly...not up as my earned income will drop substantially....
4. The government obviously needs the tax revenue these conversions will bring in. How long before they change the rules again? At some point with the younger generation contributing to Roths...the potential revenue stream from them may be so large the government may go after it.
5. Still.....I may look at converting a small amount of money. Will be investigating again....between now and next April..
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Old 09-08-2010, 03:45 PM   #19
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I've been doing a little each year for the last few years. I'm not really sure how much of an advantage it is for me so I'm just moving a little at a time.
So when the time comes to use this money I'll only be a little wrong no matter what happens.
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Old 09-08-2010, 03:47 PM   #20
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Apologies if this was already mentioned... but one of the main reasons I chose to convert this year was that I plan on leaving $ for kids (currently no trust structure)... and I think the tax free, no RMD would allow it to hopefully compound across our retirement years - compared to 401k.
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